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Bonds are often considered a “safe” asset class. They can be less volatile than stocks in the short term and potentially provide a relatively steady income source over time. But bonds aren’t free 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 goals and investment strategy.
A bond’s yield, or coupon rate, 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 charge higher loan rates to risky borrowers, higher bond interest rates (or coupon rates) can indicate a higher risk of default; lower-rated bonds tend to offer higher yields.
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.
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 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 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.
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.
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.
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.
Corporate bonds can be divided into a few general categories: Investment-grade corporates, high-yield or junk bonds and distressed debt.
Bonds are sometimes assumed to be generally safe investments, but that is not necessarily always the case. Bonds are not totally free of any risk Nevertheless, bonds might play an important role in your investment strategy. We believe every investor should practice the same due diligence and research when investing in the bond market as they would when investing in the equity market. Contact Fisher Investments today to learn more about bond risks and whether bonds are right for you.