There are always certain risks associated with investing in the financial markets. Some of those risks are obvious to investors, such as investing in a company that has yet to generate a profit. Other risks are more subtle. Event risk represents the amount of risk associated with unseen developments that are directly pursued by or tied to a company. These events can ultimately trigger robust trading activity or volatility in a financial instrument, such as a bond, that can cause erratic changes in the value of an investment portfolio, which is an allocation of all investments.
One endeavor that can cause event risk in a company is if that entity decides to add to its debt load. Reasons for issuing debt in the capital markets could be to fund a project, such as an oil drilling opportunity for an energy company, a clinical trial for a pharmaceutical stock or developing new technologies at a software company. These can be capital-intensive endeavors, and therefore, the company will turn to the equity or debt capital markets for help.
Issuing equity or stock is not always ideal. Equity issuance tends to be more expensive than debt issuance. Additionally, by issuing more stock in the financial markets, a company is diluting the percentage holdings of current shareholders. As a result, a company might decide to issue bonds.
The event risk tied to bond issuance arise from the possibility that a company is loading on too much debt in relation to equity. Once debt is issued, the company must maintain ongoing interest payments to investors for the term of the bond security. After the bond matures, or expires, the company must repay investors the face value of that investment, which requires discipline with the cash flow that is being generated.
A company with tight cash flow and excessive amounts of debt reflects event risk. This scenario could materially impact a bond's yield or returns. If financial analysts or third-party rating agencies decide that the debt load of a company is too heavy, it could lower the rating on that company or issue a warning, which in turn could be reflected in the bond's value.
If a company is unable to keep up with interest payments and principal payments on its debt, it eventually might be forced into bankruptcy, which is another event risk. Even if that company intends to undergo a corporate restructuring, which is a reorganization of its debt on more favorable terms in an attempt to reattain profitability, there is no guarantee of success and ultimately emerging from a bankruptcy situation. Bondholders have no guarantee of being paid if a company is forced to liquidate assets to repay its creditors, but bond investors have priority over stockholders, which means they have a greater chance of being paid something.