Bonds for Retirement

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.

Interest Rate Risk: Interest rates and bond prices move inversely—meaning when interest rates fall, the value of fixed income investments rises, and when interest rates go up, bond prices fall in value. If an investor sells their bond holdings before maturity in a rising interest rate environment, they could realize 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.

Re-investment 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 might 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, the 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 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.

Differentiating Bonds

With a large universe of fixed income securities globally, differentiating between bonds is crucial. There are many ways to break down the bond market—here are a few common categories.

Government Bonds: Government bonds are those issued by a sovereign nation—US Treasurys, UK Gilts, Japanese Government Bonds (JGBs) and German Bunds are some examples.

Agency Bonds: Agency bonds are those issued by divisions of (or organizations sponsored by) the US Federal Government. Many have characteristics similar to Treasurys, as there is a presumption an Agency would be backed by the US Government in the event of financial trouble.

Municipal Bonds: Sometimes called “munis,” these bonds are issued by states, cities, counties, and other government entities. In general, the interest on a municipal bond is free from federal tax.

Corporate Bonds: These bonds are issued by a private or public company. An investor purchasing a corporate bond is lending a corporation money for a specified period of time. Corporates can generally be broken down into two broad categories: High-yield (junk) corporates and investment-grade corporates. High-yield bonds carry more credit risk (a greater likelihood of default). They, therefore, tend to carry higher interest rates and see greater volatility. Investment-grade firms are more established and generally carry less credit risk and pay less interest.

What are the Characteristics of Bonds?

Yield: The amount of realized return on a bond.

Duration: A measurement of a bond’s price sensitivity to changes in interest rates.

Maturity: The time from issuance until the principal of the bond is paid back.

Coupon: The annual amount of interest paid on a bond, usually expressed as a percentage (or coupon rate).

Issuer: The issuer of a bond can be a corporation, municipality, government or government agency, each of which carries different risk and return characteristics.

As an investment manager, Fisher Investments doesn’t focus on any one asset class—we manage a variety of strategies including stocks, bonds, cash and other securities. The optimal portfolio strategy for you will depend on your specific investment objectives, time horizon, cash-flow requirements, outside income and assets, and any restrictions or customizations you may have. Contact Fisher Investments today to learn more about bond risks and whether bonds are right for you.