Finance in a Nutshell – A no-nonsense companion to the tools and techniques of finance : [PDF Download]

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“Suppose we buy a corporate bond that matures in five years but that we intend to hold for only one year. What can go wrong? What are the sources of risk we face? Can we actually lose money?

In a nutshell, many things can go wrong, because bonds are risky in more than one way, and yes, we can lose money by investing in this or in any other bond. Just to drive this point home, note that even investors in ‘super-safe’ US Treasury bonds can lose money.

Long-term Treasuries delivered negative returns of 9% in 1999, 1% in 1996, and 8% in 1994. The first and obvious source of risk is that the company defaults on its payments. Let’s say the company goes bankrupt; not only does it not make the coupon payment we expected for the year we hold the bond bu nor will it make any other payment in the future (coupons or principal).

Well, that’s too bad. We just suffered a 100% loss on our investment. We’ll discuss this possibility in more detail below, but for the time being let’s call this default risk, that is, the uncertainty about whether the company will make the bond’s promised payments.”

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