Risks of Bonds

Compared to other investments, bonds score very well in the risk department and are certainly more stable generally than stocks are. Of course, this depends on the type of bonds that we invest in, and some have more risk than others, particularly those who have lower ratings and therefore are at greater risk of default.

Other bonds, the higher rated ones, can take thoughts of default risk right out of the picture, and people don’t generally have any qualms about the highest rated ones, nor should they really worry here.

Risks of BondsWhile there are several types of risks associated with bonds, the most prominent one is not having the terms of the bond be honored, in other words, the money that has been lent to the bondholder not being paid back in a timely way.

Bond defaults don’t involve the bonds losing value, as a stock might, as this means that an interest payment that was due at a certain point of time has not been made. Bonds typically make annual payments to bondholders at a certain rate of interest, and in order to prevent default, these payments need to be made, in the same way that we would need to keep making payments on a personal loan to keep from defaulting.

The nature of the bond market does allow us to choose a level of default risk that we are comfortable with, which generally means one that is very low, although we do have a choice here. This allows bond risks to be priced in the market and also ensures that there are markets for a wide variety of default risks, from virtually zero to considerable.

Therefore, of all the risks involved in investing or trading in bonds, default risk is the potentially biggest one but is also one that can be easily managed. One first selects bonds according to one’s appetite and preference for default risk, and if this situation changes, one can still liquidate one’s positions in favor of a more suitable investment.

Interest Rate Risk with Bonds

The second prominent risk with bonds is interest rate risk, and unlike default risk, we can’t just choose to invest in certain bonds that have a very low or virtually no risk profile with this one.

When a bond is issued, it generally will provide its purchasers with a certain interest rate over time, and this rate is based upon the market conditions at the time of issue. If interest rates are very low for instance, then the rate of the bond will be low as well, and the rates that the market will demand for it will be dependent on the interest rate market generally at this point in time.

If later, interest rates rise significantly, the newer bonds that become issued will be offering higher rates of course. You bought the bond when it was only paying 1%, and the new ones are now offering 2%, so the value of the bond you bought will be less. If you look to sell it, you will get less for it than you paid for it, as you can’t expect someone to pay $1000 for your 1% interest rate bond when they could buy one with a 2% rate for the same price.

If rates go down, the reverse happens. Let’s say that you bought a bond with a rate of 3% and similar bonds are now offering just 2%. Your bond is then worth more than the new ones, and you could sell it for more than what you paid for it based upon that.

Since the rates do not change with a given bond, something has to give when interest rates change, and what changes is the price of the bond if it were to be sold. That’s an important part of the equation, as this is the only time that the price matters, when you sell.

That’s true of stocks as well, but the difference with bonds is that they can simply be held to maturity where you will earn the rate of interest on the bond and get your money back at maturity, the full face value. While it is true that there still would be interest rate risk from an opportunity cost perspective, for instance the extra money you could have made if you had waited until interest rates went up, this risk at least doesn’t result in your losing money with a buy and hold approach to bonds.

This does not necessarily mean that buying and holding bonds is preferable generally, although in some circumstances it certainly may be, and this approach does make a lot more sense with bonds than it does with stocks. People are told that the buy and hold approach with stocks is an way to manage risk, when in reality, it doesn’t manage risk at all. It can though with bonds if one has the means and the desire to pursue it and it is appropriate for their financial goals as well.

If bonds are to be bought and sold, if one is looking to time them, then changes in interest rates will matter, and matter a lot, as this is the main driver of bond pricing.

Inflation Risk

Inflation risk is one that a lot of people don’t take into account properly, and while it is related to interest rate risk, there are some meaningful differences.

When we buy a bond, we are committing our money at a certain interest rate, with the expectation that this rate will provide a certain level of net income, net of inflation.

If inflation rises more than expected, and it is not priced into the return of the bond, this will cause our net return to decline. If inflation rises a lot, this can cause us to not only fail to generate income from the bond, it can also lead to our losing money on a net basis from it.

Let’s say we have a million dollars saved up from all the years of saving while we were working, and now retire and buy a bond that pays 3% over 10 years. Initially, we may be pretty happy with that, with the $30,000 that we will earn each year from the bond, adding to whatever else we have and providing us with an income level overall that we expect to be comfortable on.

At the end of the 10 years, we will have earned $300,000 in interest, and get our million dollars back, and we’re choosing to hang on to the bond and enjoy this income it will provide. Let’s say that interest rates start rising after we buy it and average 6% each year over these 10 years.

Each year, the value of our million dollar investment declines by $60,000, and the $30,000 we make in interest only covers half of that. The investment over the 10 years then results in a net loss for us of $300,000. We still have the million left but it is now only worth $700,000 in today’s dollars.

Each year, while we hold the bond, the real value of that $30,000 a year declines, by the 6% per year. Initially, this doesn’t seem like a big deal, and in year one the value of this income only goes down to $28,200 a year. It declines by a further $1,800 a year until maturity though, and eventually our cutting back on our expenses may not be enough, and we may reach a point where we are not comfortable at all anymore.

Therefore, we need to keep inflation risk in mind, and realize that in times of higher inflation, bonds aren’t quite the bargain they are when inflation is lower, and choose our investments accordingly.

Downgrade Risk

There’s also the risk that an investment’s rating may be downgraded, which is something that applies more to corporate bonds than treasuries, although even treasuries are subject to this risk.

When bonds are downgraded, this doesn’t mean that they will default necessarily, and most often they do not, but what this does mean is that they will likely lose value in the market due to the undesirability of a lower rating.

The interest that bonds pay are based upon a combination of the interest rate market at the time of issue, the demand for bonds in general, and the perceived safety of the bond. All three of these conditions affect the price of a bond, and a downgrade in rating will mean that the bonds issued by the entity will have to offer higher rates to be attractive.

If the interest rates that a certain bond is paying goes up, this means that the value of their outstanding bonds will go down, and this is on top of changes in demand that this may produce. This particular risk is in fact much more a matter of the pricing of the risk going up with a bond than the effect this may have on demand.

The higher perceived risk can usually just be priced in, but as it is, the value of previously issued bonds at lower rates become affected.

Changes in demand can be significant though, but this is more a matter of the way that changing demand of the bond market as a whole affects pricing. If there is a certain demand for bonds, then the efficiencies of the market will cause prices of bonds to be priced higher or lower depending on the circumstances.

The overall bond market does ebb and flow though, as all financial markets do, and there are times where people will move money out of bonds and into other investments, and vice versa as conditions change. If the stock market is in a down phase, bonds can become more attractive, and during bull markets, stocks can become more regarded and popular.

Market risk is less of a concern with bonds than they are with stocks though, due to the performance of bonds being at least somewhat independent of the supply and demand for them at any given time, where with stocks, supply and demand exert a much more prominent effect on performance.

Bonds can be the safest investment you can make in securities though, generally speaking anyway but this is only true generally and we must properly account for the factors that influence bond risk if we are truly going to be managing investment risk overall.

John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.

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