Seasoned investors know the importance of diversification. Creating a portfolio that mixes asset classes—stocks, currencies, derivatives, commodities, and bonds—is probably the best way to generate consistent returns.
Although bonds may not necessarily provide the biggest returns, they are considered a 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.
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.
- Interest rate risk is the potential for a bond's value to fall in the secondary market due to competition from newer bonds at more attractive rates.
- Reinvestment risk is the possibility that the bond's cash flow will go into new issues with a lower yield.
- Call risk is the likelihood that a bond's term will be cut short by the issuer if interest rates fall.
- Default risk is the chance that the issuer will be unable to meet its financial obligations.
- Inflation risk is the possibility that inflation will erode the value of a fixed-price bond issue.
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.
Bonds, bond funds, and bond exchange-traded funds (ETFs) can be purchased through online brokers or full-service brokers.
Federal government bonds can be purchased directly from the government's TreasuryDirect website.
Interest Rate Risk
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. If you sell it in the secondary market, the bond will then trade at a discount to reflect the lower return that the buyer will make on the bond.
This is why interest rates are said to have an inverse relationship with bond prices.
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 explained by the changes in 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
Say you bought a 5% coupon, a 10-year corporate bond that is selling at par value of the $1,000. If interest rates jump to 6%, the market value of the bond will fall below $1,000 because the 5% fixed interest that it pays grows less attractive as newly issued bonds will yield a full percentage point higher for bondholders. As a result, the original bond will trade at a discount in order to compensate for this difference.
Supply and Demand
Interest rate risk can also be understood in terms of supply and demand. If you purchased a 5% coupon for a 10-year corporate bond that sells at par value, you would expect to receive $50 per year, plus the repayment of the $1,000 principal investment when the bond reaches maturity.
Now, what would happen if market interest rates increased by one percentage point? A newly issued bond with similar characteristics as the originally issued bond would then 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 the bond in a rising interest rate environment because a buyer could purchase a newly issued bond that pays a higher coupon amount.
The bond issuer would have to sell it at a discount from par value. The discount would have to make up the difference in the coupon amount in order to attract a buyer.
Another risk associated with the bond market is reinvestment risk. A bond poses a reinvestment risk if its proceeds will need to be reinvested in a security with a lower yield.
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.
A bond can be issued with a call provision that allows the issuer the option to retire it early. The principal is repaid in full and the agreement to pay interest is canceled.
This is usually done when interest rates fall substantially since the issue date. The issuer can retire the old, high-rate bonds and issue a new round of bonds at a lower rate of interest.
Default risk is the possibility that a bond's issuer will go bankrupt and will be unable to pay its obligations in a timely manner if at all. If the bond issuer defaults, the investor can lose part or all of the original investment and any interest that was owed.
Credit rating services including Moody's, Standard & Poor's, and Fitch give credit ratings to bond issues. Their ratings are an evaluation of the financial soundness of the bond issuer and are intended to give investors an idea of how likely it is that a default on its bond payments will occur.
For example, the U.S. and many other national governments have very high credit ratings. They have the means to pay their debts by raising taxes or printing money, making default extremely unlikely.
However, some struggling nations have very low credit ratings, indicating that they are more likely to default on their bond payments. Their bondholders may lose some or all their investments.
Low-rated bonds are also known as junk bonds.
Just as inflation erodes the buying power of money, it can erode the value of a bond's returns. Inflation risk 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 is effectively losing 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.
Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal. Investors should consider engaging a qualified financial professional to determine a suitable investment strategy