Seasoned investors know the importance of diversification. Mixing up your portfolio with different asset classes is probably the best way to generate consistent returns—stocks, currencies, derivatives, commodities, and bonds. Although bonds may not necessarily provide the biggest returns, they are considered a fairly reliable investment tool. That's because they are known to provide regular income. But they are also considered to be a stable and sound way to invest your money because—especially those offered by the government—are guaranteed. That doesn't mean they don't come with their own risks.

As an investor, you should be aware of some of the pitfalls that come with investing in the bond market. Here's a look at some of the most common risks.

Key Takeaways

  • Although bonds are considered safe, there are pitfalls like interest rate risk—one of the primary risks associated with the bond market.
  • Reinvestment risk means a bond or future cash flows will need to be reinvested in a security with a lower yield.
  • Callable bonds have provisions that allow the bond issuer to purchase the bond back and retire the issue when interest rates fall.
  • Default risk occurs when the issuer can't pay the interest or principal in a timely manner or at all.
  • Inflation risk occurs when the rate of price increases in the economy deteriorates the returns associated with the bond.

Basics of Bond Investing

Bonds are a form of debt issued by a company or government that wants to raise some cash. In essence, when an entity issues a bond, it asks the buyer or investor for a loan. So when you buy a bond, you're lending the bond issuer money. In exchange, the issuer promises to pay back the principal amount to you by a certain date and sweetens the pot by paying you interest at regular intervals—usually semi-annually.

Although bonds are considered safe investments, they do come with their own risks.

While stocks are traded on exchanges, bonds are traded over the counter. This means you have to buy them—especially corporate bonds— through a broker. Keep in mind, you may have to pay a premium depending on the broker you choose. If you're looking to buy federal government bonds like U.S. Treasury Securities, you can do so directly through the government. You can also invest in a bond fund which is a debt fund that invests primarily in different types of debts including corporate, government and municipal bonds, as well as other debt instruments.

Interest Rate Risk

The most well-known risk in the bond market is interest rate risk. Interest rates have an inverse relationship with bond prices. So when you buy a bond, you commit to receiving a fixed rate of return (ROR) for a set period. Should the market rate rise from the date of the bond's purchase, its price will fall accordingly. The bond will then trade at a discount to reflect the lower return that an investor will make on the bond.

The inverse relationship between market interest rates and bond prices holds true under falling interest-rate environments as well. The originally issued bond would sell at a premium above par value because the coupon payments associated with this bond would be greater than the coupon payments offered on newly issued bonds. As you can infer, the relationship between the price of a bond and market interest rates is simply explained by the supply and demand for a bond in a changing interest-rate environment.

Market interest rates are a function of several factors including the supply and demand for money in the economy, the inflation rate, the stage that the business cycle is in, and the government's monetary and fiscal policies.

Example of Interest Rate Risk

If you bought a 5% coupon, a 10-year corporate bond that is selling at par value, the present value of the $1,000 par value bond would be $614. This amount represents the amount of money needed today to be invested at an annual rate of 5% per year over a 10-year period, in order to have $1,000 when the bond reaches maturity.

If interest rates jump to 6%, the present value of the bond would be $558 because it would only take $558 invested today at an annual rate of 6% for 10 years to accumulate $1,000. But if interest rates decreased to 4%, the present value of the bond would be $676.

Supply and Demand

Interest rate risk is also fairly easy to understand in terms of supply and demand. If you purchased a 5% coupon for a 10-year corporate bond that sells at par value, the investor would expect to receive $50 per year, plus the repayment of the $1,000 principal investment when the bond reaches maturity. Now, let's determine what would happen if market interest rates increased by one percentage point. Under this scenario, a newly issued bond with similar characteristics as the originally issued bond would pay a coupon amount of 6%, assuming it is offered at par value.

For this reason, the issuer of the original bond would find it difficult to find a buyer willing to pay par value for their bond under a rising interest rate environment because a buyer could purchase a newly issued bond in the market that pays a higher coupon amount.

As a result, the bond issuer would have to sell it at a discount from par value in order to attract a buyer. The discount on the price of the bond would be the amount that would make a buyer indifferent in terms of purchasing the original bond with a 5% coupon amount, or the newly issued bond with a more favorable coupon rate.

Reinvestment Risk

Another risk associated with the bond market is called reinvestment risk. In essence, a bond poses a reinvestment risk to investors if the proceeds from the bond or future cash flows will need to be reinvested in a security with a lower yield than the bond originally provided. Reinvestment risk can also come with callable bonds—investments that can be called by the issuer before the maturity rate.

For example, imagine an investor buys a $1,000 bond with an annual coupon of 12%. Each year, the investor receives $120 (12% x $1,000), which can be reinvested back into another bond. But imagine that, over time, the market rate falls to 1%. Suddenly, that $120 received from the bond can only be reinvested at 1%, instead of the 12% rate of the original bond.

Call Risk for Bond Investors

Another risk is that a bond will be called by its issuer. Callable bonds have call provisions that allow the bond issuer to purchase the bond back from the bondholders and retire the issue. This is usually done when interest rates fall substantially since the issue date. Call provisions allow the issuer to retire the old, high-rate bonds and sell low-rate bonds in a bid to lower debt costs.

Default Risk

Default risk occurs when the bond's issuer is unable to pay the contractual interest or principal on the bond in a timely manner or at all. Credit rating services such as Moody's, Standard & Poor's, and Fitch give credit ratings to bond issues. This gives investors an idea of how likely it is that a payment default will occur. If the bond issuer defaults, the investor loses part or all of their original investment plus any interest they may have earned.

For example, most federal governments have very high credit ratings (AAA). They have the means to pay their debts by raising taxes or printing, making default unlikely. However, small emerging companies have some of the worst credit—BB and lower—and are more likely to default on their bond payments. In these cases, bondholders will likely lose all or most of their investments.

Inflation Risk

This risk refers to situations when the rate of price increases in the economy deteriorates the returns associated with the bond. This has the greatest effect on fixed bonds, which have a set interest rate from inception.

For example, if an investor purchases a 5% fixed bond, and inflation rises to 10% per year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. The interest rates of floating-rate bonds or floaters are adjusted periodically to match inflation rates, limiting investors' exposure to inflation risk.