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When considering investing in any form of asset it is worth considering the risk versus reward continuum. Generally, lower risk investments provide lower returns. Australian Government bonds are considered risk free and thus offer relatively low returns. One way to gauge risk is to refer to a government or corporation's credit rating. Another is to look at historical volatility, that is, by how much returns have varied by asset class (see the figure below).
Source: FIIG Securities
Investors in Australian securities would expect the lowest return from government bonds, with returns increasing as risk increases along the continuum. Generally, senior and subordinated debt (bonds) are low risk and should provide a lower return than hybrid securities with equity (ordinary shares) higher in terms of risk and expected reward.
Interest rate risk - the risk associated with an interest-bearing asset, such as a loan or a bond, due to variability of interest rates.
Early redemption or call risk - the risk faced by a holder of a callable bond that a bond issuer will take advantage of the callable bond feature and redeem the issue prior to maturity. This means the bondholder will receive payment on the value of the bond and, in most cases, will be reinvesting in a less favourable environment (one with a lower interest rate).
Credit or default risk - this is the risk that the issuer may be unable to meet the interest and/or capital repayments when due, that is default on the loan. Generally, the higher the credit risk of the issuer, the higher the interest rate that investors will expect in return.
Liquidity risk - this is the risk that a security cannot be easily sold at, or close to, its market value.
Exchange or currency risk - arises from moves in foreign currency rates. Can be divided into transaction risk where currency fluctuations impact the proceeds of specific transactions and translation risk which affects the value of assets and liabilities on the balance sheet.
Political or country risk - the risk of loss when investing in a given country caused by changes in a country's political structure or policies, such as tax laws, tariffs, expropriation of assets, or restriction in repatriation of profits.
Event risk - risk due to unforeseen events, for example a company making a large acquisition.
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