Bonds are considered a low-risk investment vehicle and, therefore, offer a relatively modest rate of return. But there are risks involved that every investor should know about.
The two main risks that bond investors face are Default Risk and Interest Rate Risk.
Default Risk is the possibility that an issuer will not be able to meet the obligations of its bonds, namely, that it won’t have the money to pay its coupon (interest) or to repay the principal upon maturity. When an issuer defaults, investors will usually lose all or most of their investment.
Default risk is what determines the coupon, or interest rate, on a bond. A financially strong company with a history of meeting its obligations will issue bonds with a relatively low interest rate; conversely, a startup that has never reported profits and has defaulted on obligations in the past will issue bonds at a higher interest rate because there is a higher likelihood that it will default.
Diversification is the key to managing default risk. “Don’t put all your eggs in one basket,” is the applicable saying here. While credit reporting agencies like Moodys and Standard and Poors offer bond ratings that give investors an idea of the likelihood of default, no company is immune to the possibility: not Enron, not Argentina, not Ford, and not General Motors.
High yield bonds (junk bonds) should be kept to a minimum, unless your portfolio is extremely diverse and your investment style has a high risk for volatility, while investment-grade (highly rated) bonds should make up the majority of your bond portfolio. Government bonds should range across a wide spectrum of countries and governments. We all like the tax benefits of municipal bonds, but they have a much higher default risk than federally-issued Treasuries.
Also, pay attention to the duration of bonds. A short-term bond will have a lower risk of default than a long-term bond, since there is less time for an issuer to meet its obligations. As a result, short-term bonds will have a lower interest rate.
Interest Rate Risk is the risk that your investment will lose money because market interest rates have risen. Everyone talks about this every day in the financial press, and it’s how bond traders make their living. It is widely known that higher interest rates mean lower bond prices, but it is little understood.
Every time Fed Chairman Bernanke sneezes it affects the bond market, but few know exactly why.
So, here’s the lowdown:
When an investor buys a bond he or she is expecting a fixed rate of return for a specified period of time. Let’s say I buy a 20-year US Treasury bond for $10,000, and it has an annual coupon of 5%. From my $10,000 investment, I expect to get $500 a year (5% of $10,000) for the next 20 years, at which point I’ll get my $10,000 principal back.
Well, if interest rates go up and the US Treasury now issues 20-year bonds for 10%, I made a bad investment. Now, my $10,000 investment could have bought a bond that yields $1,000 a year, twice as much as my piddling $500 annually. The result is that, if I were to sell my $10,000 bond, I would get less than half of my investment, since the same issuer (the US Treasury) is now issuing bonds at twice the interest rate.
This example is simplified and exaggerated. Treasuries don’t double their coupon overnight. Also, there is only one issuer in the example given above.
Imagine the scenario above played out across the entire bond universe: short-term, medium-term, long term; municipal, government, and corporate bonds; high-yield, emerging market, and investment-grade…
Throw oddballs like asset-backed securities, convertible bonds, and mortgage-backed securities and you can begin to see how interest rates affect the entire bond universe: when interest rates rise, bond prices fall. It’s that simple.
The only hedges against inflation risk are liquidity (cash) and hard assets. The ability to purchase bonds when interest rates are high is the important thing: new issues have a high interest rate, and the secondary market is depressed (think about that $10,000 bond I bought that could now be bought for $5,000).
There are other risks of bond investments, and I’ll go over them briefly.
Inflation Risk is the possibility that the coupon on your bond will not meet inflation. For instance, if inflation is 4% and your bond investment only returns 3%, you effectively lost 1% annually by investing.
Country Risk is the risk that a government bond will go into default because the issuing government is unstable or insolvent.
Call Risk, unique to callable bonds, is the risk that an issuer will call a bond, thereby canceling it, by repaying the principal before maturity.