For most investors, the best investment opportunity for them to gain practical experience with the capital markets is fixed income. There are many types of fixed income securities to choose from, including sovereign debt, corporate debt, mortgage-backed securities and asset-backed securities, to name a few. Given the breadth of fixed income securities that are available to purchase, it is important for investors to have a general understanding of their risks before making an investment decision. In most cases, the risks associated with fixed-income securities can be classified as default risk, downgrade risk, credit-spread risk and interest-rate risk. Technically speaking, default risk is the most important type of risk that investors should be concerned with, because a technical default would mean that the issuer has failed to make a periodic coupon payment over the term of the loan, or that the issuer did not return the principal investment to the investor when the bond matured. Fortunately, this type of risk is easy for most investors to understand, although it is more difficult for them to analyze. Downgrade risk is also a type of risk that is relatively straightforward to understand, because it simply represents the potential for a reduction in the value of a bond that would result if a credit rating agency lowered the credit rating on the company that issued the bond. Credit-spread risk is a little more complex to understand, but it can be conceptualized as a change in the price of a bond that would result if the spread between the interest rate for the risky bond and the interest rate for a risk-free bond changed after the risky bond was purchased.... Continue to read.
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