Section 3.4 — Risks of Debt Securities

  • 💵 Bonds as Income Investments

    • Bonds are one of the best ways to generate current income for investors.

    • They provide regular interest payments, often semiannually.

    • Because of this stable income, they’re commonly used by retirees or income-focused investors.

⚠️ Primary Risks of Debt Securities

1. Default Risk (Credit Risk):

  • The risk that the issuer fails to pay interest or principal when due.

  • U.S. Treasury securities have no default risk — they are backed by the full faith and credit of the U.S. government.

  • Therefore, Treasuries are considered the safest investments in the world.

2. Interest Rate Risk:

  • The price of bonds moves inversely to interest rates:

    • When interest rates rise, bond prices fall.

    • When interest rates fall, bond prices rise.

  • This is true for all fixed-income securities.

  • The longer the bond’s maturity, the greater the interest rate risk.

3. Purchasing Power Risk (Inflation Risk):

  • The risk that inflation erodes the purchasing power of a bond’s fixed interest payments.

  • Inflation reduces the real value of future interest and principal.

  • This affects all fixed-payment securities, including:

    • Bonds

    • Preferred stock (even though it’s equity, it pays a fixed dividend)

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⚡ Summary Table

Risk Type / Description / Who It Affects / Example

  • Default Risk / Issuer fails to make payments / Corporate bonds (not Treasuries) / A company goes bankrupt

  • Interest Rate Risk / Bond prices fall as rates rise / All fixed-income securities / Market rates increase → bond prices drop

  • Purchasing Power Risk / Inflation decreases value of fixed payments / Bonds and preferred stock / Inflation rises faster than bond interest

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✺ Review questions ✺

  • They provide current income through regular interest payments.

  • Default risk — the issuer might fail to pay interest or principal.

  • U.S. Treasury securities

  • Inversely — when interest rates rise, bond prices fall.

  • The risk that inflation reduces the real value of fixed interest payments.

  • Preferred stock (because it pays a fixed dividend)