When it comes to diversifying a portfolio, bonds are often a popular choice due to their stable income stream and relatively conservative risk profile. However, not all bonds are low risk, and it’s important to understand the various risks associated with different types of bonds.
Let’s take a closer look at the risks associated with bonds and why some are considered safer than others.
Understanding Bonds
Bonds are essentially a contract between an investor and the entity issuing the bond, whether it’s a company or government. The issuer agrees to pay the investor a specified amount over a set period of time, with the principal amount returned at maturity. Bonds are a form of debt security.
The periodic interest payment to the investor is known as a coupon, which typically remains fixed unless stated otherwise. There are two main types of bond payments: fixed and floating rate payments. Fixed payments involve a set interest amount, while floating rate payments adjust based on current interest rates.
Unlike stocks, where prices are influenced by company performance, bond prices are heavily impacted by interest rate movements. Changes in interest rates directly affect bond prices, with rising rates leading to lower bond prices and vice versa. This relationship causes bond yields to fluctuate inversely with prices.
Are Some Bonds Safer Than Others?
The safety of a bond depends on various factors, including the investor’s financial goals, the type of bond, and the issuer. Here are four key risk factors to consider when evaluating the safety of a bond:
1. Default and Credit Risk
Credit risk pertains to the overall risk associated with the bond issuer’s ability to repay the investor. Factors such as economic conditions and financial health can impact the issuer’s ability to make payments. Checking the issuer’s credit rating is crucial in assessing credit risk.
Default risk specifically refers to the possibility of the issuer failing to meet interest payments or repay the principal. Credit ratings from agencies like Moody’s and S&P Global provide insight into default risk.
Types of bonds more affected by default risk: Corporate bonds, high-yield bonds, some municipal bonds, and asset-backed securities.
2. Inflation and Interest Rate Risk
Inflation can erode the purchasing power of a bond, reducing the value of future interest payments and the principal. Rising inflation prompts central banks to increase interest rates, causing bond prices to fall. Conversely, falling interest rates lead to higher bond prices.
Types of bonds more affected by interest rate risk: Long-term government bonds, corporate bonds, mortgage-backed securities, municipal bonds, and zero-coupon bonds.
3. Reinvestment Risk
Reinvestment risk arises when bond cash flows are reinvested at lower rates than the original bond yield, reducing overall returns. Declining interest rates increase reinvestment risk as investors struggle to reinvest at higher yields.
Types of bonds more affected by reinvestment risk: Callable bonds, short-term bonds, zero-coupon bonds, mortgage-backed securities, and asset-backed securities.
4. Liquidity Risk
Liquidity risk occurs when selling a bond below its true market value due to limited buyers or demand. Less liquid bonds may need to be sold at a discount, resulting in lower-than-expected returns.
Types of bonds more affected by liquidity risk: High-yield bonds, municipal bonds, some corporate bonds, mortgage-backed securities, and asset-backed securities.
Bonds vs. Bond Funds: Different Risks
Investors often turn to bond funds for diversification and professional management, as these funds hold a variety of bonds with different maturities. While bond funds offer liquidity similar to stocks, they also come with risks such as interest rate fluctuations and management risk.
Despite the risks, investors are drawn to bond funds for potential price appreciation, stable income, and higher yields compared to new bonds issued at lower rates. Ultimately, investors must weigh the risks associated with bonds and bond funds when allocating assets in their portfolio.
Conclusion
While bonds are generally considered less risky than stocks, they carry their own set of risks that investors should carefully consider. Evaluating the issuer, type of bond, and specific risk factors can help investors make informed decisions about their portfolio allocation.