The mainstays of investing for the vast majority of portfolios are equities and bonds. Many people think of bonds as safe investments, especially when compared to stocks. While bonds can be safer than stocks in many ways, there are some risks that you should understand when it comes to these securities.
The risks involve both corporate and government bonds, so it is not necessarily less risky to invest in one over the other. Understanding the potential pitfalls of investing in bonds can help you make the best decisions when it comes to building a portfolio that is diversified and balanced in terms of risk and potential for return.
The key risks of investing in bonds to recognize include:
1. Inflation Risk:
Buying a bond means entering a contract for a specific rate of return for as long as the security is held. This rate of return may be fixed or variable depending on the terms of the specific bond. Inflation risk is when this rate of return is less than the rate of inflation.
When cost of living increases at a fast rate, bond returns may not keep up with inflation. This means that purchasing power actually decreases over time. You may end up with a negative rate of return once you factor in inflation.
For example, if your bond provides a 3 percent return but inflation is 4 percent, your rate of return would be negative. Always pay attention to trends in inflation and look for investments with a high enough rate of return to keep you in the positive.
2. Liquidity Risk:
Once you purchase a bond, you may not be able to sell it easily if you need income. Historically, there has almost always been a market for government bonds, so these investments tend to be fairly liquid. However, the same does not hold true for corporate bonds.
When there are few buyers and sellers for corporate bonds, you may be put in a difficult place should you need liquidity. Moreover, low interest in a bond can lead to price volatility and affect the return you get once you finally find a buyer. The same holds true for stocks. If there are not many willing buyers, you may need to sell at a far lower price than you initially expected when you liquidate.
3. Interest Rate Risk:
One of the major risks involved in investing in stocks has to do with interest rates. An inverse relationship exists between interest rates and bond prices. This means that bond prices increase when interest rates fall and vice versa. When interest rates fall, investors attempt to lock into the highest rates they can for as long as possible.
Thus, investors will readily buy existing bonds that pay higher interest rates, which drives bond prices. However, if the interest rate is rising, then investors will try to unload their bonds, which pushes prices down. You should always pay close attention to interest rate trends as you invest in bonds.
4. Default Risk:
A bond is essentially a certificate of debt. When companies issue bonds, they are borrowing money that they promise to repay over time with interest. Unfortunately, corporate bonds do not have any guarantees and returns depend entirely on the issuer’s ability to repay the debt. Thus, default is always a potential risk when investing in corporate bonds.
Different approaches exist for managing that risk. One common approach is determining the coverage ratio of a company issuing bonds. You will need to look at income and cash flow statements form the company and then figure out operating income and cash flow.
Weigh this number against the expense of the debt. Greater coverage, which means more cash flow or operating income compared to debt expenses, typically means a safer investment. However, there is always risk involved.
5. Reinvestment Risk:
People who invest in bonds are sometimes subject to reinvestment risk, which is when you are forced to reinvest at lower rates than what the security previously earned. This risk is present with callable bonds.
The callable feature makes it possible for issuers to redeem a bond before it matures. When this happens, you will receive the principal payment, usually at a slight premium to the par value. Then, you have cash in place of the investment and will not always be able to reinvest and get a comparable rate of return.
Callable bonds tend to pay higher rates of return than similar investments without this feature to compensate for this risk. If you choose to invest in callable bonds, you should stagger the call dates of different bonds to avoid the potential that they all get called at once, which could put you in a very difficult position.
6. Rating Downgrade Risk:
All bonds receive a rate from institutions like Standard & Poor’s or Moody’s. These ratings range from AAA for bonds with the highest credit quality to D, which represents bonds in default. The judgments made by these agencies have a big impact on the decisions that investors make.
Furthermore, banks and lending institutions may look at these ratings and refuse future loans or charge higher interest rates when they start to fall. If this happens, the company may no longer be able to pay its debts, which could cause default. Even if default does not happen, it may become more difficult to sell that particular bond. All bonds have the risk of being downgraded should the financial situation of the issuer change.