Bond investing: Riskier than you might think
While many investors focus on stocks and give little thought to investing in bonds, allocating a portion of their portfolios to bonds is usually advisable. These fixed-income investments can provide liquidity and stability to a portfolio, and also create a steady stream of income for retirees or others who need fixed income to meet current expenses.
Many investors think of bonds as very safe investments that never lose value. However, several types of risk might be present for someone investing in individual bonds or bond mutual funds. Anybody who owns bonds, or is planning on doing so, should understand these risks.
- Interest Rate Risk. When interest rates rise, the value of a bond (or bond mutual fund) falls, and vice-versa. This is because if you own a bond paying 5% interest and interest rates then rise so that bonds of comparable quality and maturity are paying 6%, you will have to lower the price of your bond to induce someone to buy it from you. This risk is not a factor if you hold an individual bond until its maturity.
- Credit Risk. All else being equal, the lower a bond’s credit rating, the higher its stated interest rate should be to compensate investors for the added risk assumed. “Investment-Grade” bonds are those rated in one of the top four highest rating categories used by the major credit rating firms. Bonds rated below the top four categories are considered to be speculative investments.
- Reinvestment Risk. This is the risk that interest rates might be lower at the time you receive and reinvest principal and interest payments in the future.
- Inflation Risk. Unless a bond has an inflation component built into its interest rate (such as TIPS or I-Bonds), inflation will affect the “real” return earned by an investor – the interest earned less inflation.
- Event Risk. This is the risk that something unexpected could occur that impacts the ability of the bond issuer to repay. Adverse events – such as financial difficulties or a company’s product becoming obsolete – could also result in the company’s financial rating being lowered, which would decrease the values of the company’s outstanding bonds.
- Liquidity Risk. Generally, less-liquid bonds cost more to buy and sell because they are not as easy to trade. The costs of trading – such as bid/ask spreads and commissions – can be substantial and can drastically lower the bond’s effective yield.
One very important thing to keep in mind is that the longer the time until a bond matures, the higher its inflation, interest rate, and reinvestment rate risks are.
As you can see, bond investing is not as much of a sure thing as you might have thought. Perhaps you are taking on more risk than previously thought with the fixed income portion of your portfolio.
