There are a number of different risks that an investor in a bond portfolio is exposed to, but since typically higher risk means higher reward, a bond portfolio manager can manage exposure to these risks in an attempt to generate higher returns for their portfolio potentially. The main risks that a portfolio manager has to manage include interest rate risk.
When interest rates increase, the value of bonds are going to decrease.
However, not all bonds react in the same way to changes in interest rates, so portfolio managers can manage their exposure to this level of risk.
Closely associated is reinvestment risk when a portfolio manager receives cash flows from their bonds held in their portfolios from coupons or from bonds reaching their maturity date.
This money then needs to be reinvested. At the outset of an investment horizon, an assumption would be made as to the level of reinvestment return that can be achieved, and this is included within the yield to maturity calculation.
However, the yield to maturity assumes that cash flows can be reinvested at that yield.
If interest rates were to decrease, then the level of return that can be earned on reinvested cash flows will decrease.
Next is credit risk.
Credit risk identifies the risk that a borrower might not make the necessary coupon or principle repayments as they're scheduled to do, but also incorporates the fact that if the risk of that increases, there may be a decrease in the market value of a particular bond.
So credit risk doesn't just capture the risk of default, but also the reduction in market value if the perception of risk increases.
Next, we've got inflation risk.
Fixed income bonds generate a fixed rate of return for an investor, meaning that if inflation is higher than was anticipated by a portfolio manager, than the level of real return that is after inflation has been accounted for, will decrease within a portfolio.
And finally, we've got FX risk.
If you invest in overseas bonds denominated in a different currency, then there is the risk that the foreign currency may depreciate in value leading to a reduction in the value of that bond in your domestic currency.
