For any investment, you have to explore the risks and identify your limits. By doing this, you’ll make smarter decisions. And while many people think that bonds are completely safe, there are in fact varying degrees of risk. In this article, you’ll learn about the six biggest bond risks and how they can affect your portfolio.
Interest Rate Risk
Interest rate risk is probably the biggest investment risk that bond holders might encounter. And just to be clear, the interest rate that I’m referring to is not the one assigned to the bond. That’s generally a fixed rate, which is technically called the Coupon Rate.
The rates that I’m talking about are market interest rates. These are the rates in the economy that are paid on other investments as well as loans. And when market rates rise, any newly issued bonds will be assigned coupon rates that closely match market rates.
So as you might have guessed, investors will be more attracted to the new higher rate bonds rather than yours if you attempt to sell it. Your only course of action will be to either keep your bond until it matures or sell it at a discount.
It’s true that bonds are generally a safe investment. But they aren’t 100% safe, and some are safer than others. For example, if you lock into a U.S. Treasury bond, you’re going to get paid back, without a doubt.
However, corporate bonds are not backed by the U.S. government. So getting your money will depend on the company staying in business and having a healthy cash flow.
If they were to file for bankruptcy (default), that could put some or all of your investment in jeopardy.
So corporate bonds are riskier, but they also pay much higher interests than U.S. Treasury bonds.
Now, if I just put a scare into you about corporate bonds, allow me to give you a bit of comfort. You won’t be on your own when it comes to evaluating the quality and safety of bonds. There are several rating agencies such as Moody’s and Standard & Poor’s that inform investors about bond quality, issues, and risk of default.
Bonds are classified according to the following quality and risk rating system:
AAA and AA-rated bonds are the cream of the crop. These are high quality bonds that have less than a 1% chance of default.
A- and BBB-rated bonds are still considered to be solid “investment quality” instruments.
BB- and lower-rated bonds are often called junk bonds. But they are also sometimes called high-yield bonds as well. You might see approximately 2% of these bonds going into default each year.
Now, you might be thinking that there’s no way anyone in their right mind should invest in junk bonds, but lots of investors do. That’s because these lower quality bonds command higher interest (coupon) rates. And since the likelihood of the company defaulting is still pretty low, some people will take a chance. But unless you really know what you’re getting into, it’s best to avoid these bonds.
Rating Downgrade Risk
When a corporate bond is rated, it is based on attributes such as the company’s assets, net income, cash flow, debts, etc. But just because a solid rating is initially assigned when the bond is first issued, it doesn’t mean that the same rating will remain in place if the company runs into financial problems.
So if a company’s bonds are downgraded, that could impact you. That’s because there will likely be fewer people looking for bonds at the lower quality level. You might then be required to sell it at a discount in order to purge it from your portfolio.
Inflation is always an unwelcomed visitor to the economy. It makes everything more expensive. So, for example, if you have a $5,000 bond that has an annual fixed coupon rate of 3%, and the rate of inflation shoots from 2% to 5% over the life of the bond, that will erode your purchasing power.
Sure, you’ll get an annual check for the 3% or $150, but now you won’t be able to buy the same amount of goods and services. They’ll cost more.
Liquidity risk primarily applies to corporate bonds. You could run into a supply and demand issue. For example, if you have a bond that has a low quality rating and a low interest (coupon) rate, you may have a very difficult time selling it (and getting cash) if there’s not much demand for it.
This difficulty can be compounded if there are a bunch of other investors trying to unload their dog bond as well.
This risk would come into play if you have a great bond that has a high coupon rate and a “call” feature. The call feature allows the corporation to request the return and liquidation of the bond before the maturity date. They’ll usually toss you an extra bone for your troubles.
But the risk for you is that such bonds are usually “called” when market interest rates are falling. And as I mentioned in the Interest Rate Risk section of this guide, falling markets rates generally mean that existing bonds with high fixed coupon rates will increase in value and demand.
So if the rug is pulled from under you by the corporation, you’ll receive your money back plus a little extra, but then you may not be able to find a comparable investment that will give you the same or better return.
In conclusion, I hope this article opened your eyes to some of the potential traps and pitfalls associated with investing in bonds. The two most prominent bond risks are interest rate and default risks. But bond rating downgrade risk, inflation risk, liquidity risk, and reinvestment risk should not be ignored either. So keep them all in mind as you shape and expand your overall investment portfolio.
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