Bond Risks: What You Need To Know

Bonds, also known as fixed income or fixed interest securities, are a type of loan from an investor to a firm or institution. The purchaser of a bond usually receives ongoing interest for a set amount of time, in addition to receiving the original investment amount back at the end of the term. Bonds are often considered a safer asset class. They can be less volatile than stocks in the short term and potentially provide a steady income source over time. But bonds aren’t free of all types of risk.

No investment is absolutely free of risk, and bond investors should be aware of the specific risks that might be associated with their bond choices. Here we have detailed several of these risks so you can determine if this asset class suits your financial needs and investment strategy.

Credit or Default Risk

A bond’s yield is often correlated to the bond issuer’s credit risk (also known as default risk). If default risk is high, that means there is a higher risk that the bond issuer will not be able to meet all obligations of the contract. If a bond issuer’s default risk is high, they will likely offer higher yields to attract bond investors who are willing to accept the higher default risk in exchange for a higher yield. Just as banks may charge higher loan rates to risky borrowers, higher bond interest rates (or coupon rates) can indicate a higher risk of default.

Bond issuers are obligated to pay an investor the yield in accordance with the contract and pay back the principal amount at the maturity date. But what happens when the issuer cannot pay back their debt? The worst-case credit risk scenario would be an issuer defaulting on a bond you were planning to hold through its maturity. When this happens, you can lose your entire principal investment and the anticipated interest payments.

Liquidity Risk

Some bonds aren’t as easily sold as others. This is called liquidity risk. This may be due to no interested purchasers at all for a specific bond, or simply not enough trading volume to get the desired price. In a market with few buyers, bondholders may be forced to sell at a steep discount. In the worst-case scenario, there may be no one interested in buying a bond when the bondholder wants to sell it.

Interest Rate Risk

Interest rates and bond prices move inversely, which means that rising interest rates can cause prices to fall. In such a scenario, bond holdings can lose value if sold. If an investor sells these holdings before maturity, he or she could realise significant losses. This is called interest rate risk. Because of their lengthier time exposure to maturity, long-term bonds tend to be more vulnerable to interest rate risk than short-term bonds.

Reinvestment Risk

Suppose you are holding a high-coupon bond from a solvent issuer, and plan to hold it until maturity. It may seem like a low-risk, foolproof investment. But if interest rates fall as your bond matures, you might not be able to find another bond that pays out at a comparable rate and you would have to invest your principal in bond with a lower yield.

To continue your stream of comparable bond income, you may end up paying more for a bond that yields much less. This is known as reinvestment risk.

Inflation Risk

Even if you hold a bond to maturity, your actual value of your return may be different than you initially envisioned. Consider that most bonds aren’t indexed to inflation. Instead, your principal and coupon payments are set at issuance. If inflation rises, it could eventually erode the purchasing power of your interest income. This means that your coupon payment may not cover as much as you initially expected, and the final payback of the principal amount may not go as far as you anticipated at the time you made the purchase.

Even modest inflation can have a significant impact on your interest income. Suppose you anticipate requiring $50,000 annually to cover living expenses during retirement. If the average inflation rate is 3%, then in 20 years, you will need slightly less than $90,000 per year just to maintain the same purchasing power. In 30 years, you would need $120,000.

If you were counting on a certain bond payment to cover retirement expenses, don’t forget to calculate in how inflation could affect the amount you’ll need for retirement expenses.

Risks Vary According to Type

Not all risks apply equally to every bond type. Understanding the differences can help you determine the degree and type of risk you could face.

• Government bonds are issued by national governments. UK government bonds are called gilts. When issued by developed nations, these types of bonds are generally considered to carry little default risk, if any, making them one of the safest instruments available in the bond market. Despite their minimal default risk, gilts can be vulnerable to inflation risk and interest rate risk.
• Local Government Bonds, also known as authority, local authority or municipal bonds are issued by counties, cities, and other local government entities. Generally, they also have relatively low risk of default. But this doesn’t mean these bonds are risk-free. Whilst defaults are rare, they do occur.
• Corporate Bonds are issued by private companies. Among the three broad categories, corporate bonds tend to carry the highest yields, but also can be more volatile and riskier.

Corporate bonds can be divided into a few general categories: Investment-grade, high-yield and distressed debt.

• Investment-grade bonds are issued by firms that tend to be in sound financial condition. They are generally considered to carry less default risk.
• High-yield bonds have a larger credit risk or default risk due to their comparatively poor financial condition. But with their higher volatility comes higher interest payments. This volatility can sometimes make high-yield bonds fluctuate similarly to stocks.
• Distressed debt has a very high default risk, as they include companies that have a substantially higher credit risk due to their perilous financial condition. These issuers may have even already filed for bankruptcy.

What is Appropriate for my Portfolio?

Bonds are not totally free of any risk. Nevertheless, bonds might play an important role in your investment strategy. We believe every investor should practise the same due diligence and research when investing in the bond market as they would when investing in the equity market. Contact Fisher Investments UK today to learn more about bond risks and whether bonds are right for you.