Consider The Risks Before You Invest In Bonds
By definition, all investments present a balance between risk taken and the potential return. The risk is the chance you might lose some or all of the money you invest. The return is the money you can potentially make from the investment.
Different factors can impact the balance between potential risk and potential return. These include the entity which issues the investment, the state of the economy and the cycle of the securities markets. Of course, to earn higher returns, you must take a greater risk, while the least risky investments will offer the lowest rates of return.
The bond market is certainly no exception to this rule, even though bonds are generally considered less risky than stocks, for several reasons which include:
- The bond market has historically been less vulnerable to volatility or price swings than the stock market.
- While the issuer of stocks does not promise to return their face value at maturity, bonds do come with that guarantee.
- Most bonds pay a fixed rate of interest income to investors, which is backed by a promise from the bond’s issuer. While stocks will sometimes pay dividends, their issuer is under no obligation to do so.
Of course, investing in bonds does carry certain risks. Here are just a few things to consider before investing in bonds:
- Interest rate risk: Interest rates and bonds prices have an inverse relationship (when interest rates fall, the prices of bonds generally rise). Of course, this means when interest rates go up, bond prices fall. When interest rates decline, investors will try to lock in the highest rates for the longest time possible by buying existing bonds which pay a higher interest rate than the prevailing bond market. This increased demand leads to a higher bond price. If the prevailing interest rate were on the rise, investors would divest bonds that pay lower interest rates, forcing bond price downward.
- Reinvestment Risk: This is the risk of having to reinvest proceeds at a rate lower than the rate they were earning previously. This risk is triggered when, over time, interest rates fall and callable bonds (which allow the issuer to redeem the bond prior to maturity) are exercised by the issuers. When this happens, the bondholder receives the principal payment, often at a slight premium to the par value. Bond calls have a downside. Investors are left with a large amount of money which they might, or might not, be able to invest at a comparable rate, which can severely impact long-term investment returns. To try to overcome this risk, investors receive a higher bond yield than they would on a non-callable bond. To limit the chance that many bonds will be called at the same time, active investors can stagger the potential call dates of their differing bonds.
- Inflation Risk: When investors buy bonds, they commit to receiving a fixed or variable rate of return for the bond’s duration, or as long as they hold it. If the cost of living and inflation increases dramatically – at a faster rate than income investment – investors find their purchasing power fades, and can lead to a negative rate of return.
- Credit/Default Risk: Many investors do not realize that corporate bonds are not guaranteed by the U.S. government. These bonds depend on the corporation’s ability to repay the debt. Because of this, investors need to consider the possibility of default. Analysts and investors will determine a firm’s coverage ratio before making an investment, analyzing their income and cash flow statements, determining operating income and cash flow, then weigh that against its debt service expense. Investors should consider the possibility of default and factor in that risk when making investment decisions.
- Rating downgrades: Credit rating agencies such as Standard & Poor’s and Moody’s evaluate companies’ ability to operate and repay debt. Investors pay close attention to these ratings, and a downgrade can adversely affect the value of bonds.
- Liquidity Risk: Light interest in a particular bond issue can result in substantial price volatility and an adverse impact on a bondholder's total return upon sale. Similar to stocks that trade in a thin market, an investor may have to accept a markedly lower price than you would like to sell your position in the bond.
Before you invest in bonds or any other kind of financial instrument, educate yourself about the inherent risks as well as the potential upside. Partnering with a well-versed investment professional will increase your goal of having a well-rounded, healthy portfolio.
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