Investors often turn to bonds to add diversification to their portfolios, thanks to their stable income stream and relatively conservative risk profile. But not all bonds are low risk, and it’s important to understand the various risks associated with different types of bonds.
Let’s explore 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 returned at maturity. Bonds are a form of debt security.
A bond’s interest payment to the investor, known as a coupon, typically remains fixed unless specified otherwise. There are fixed and floating rate payments, with the latter adjusting based on the current interest rate environment.
Unlike stocks, where prices are influenced by company performance, bond prices are heavily impacted by interest rate movements. When interest rates rise, bond prices tend to fall, and vice versa. This inverse relationship affects the bond’s yield, which fluctuates based on price changes.
Are Some Bonds Safer Than Others?
The safety of a bond depends on various factors, including the investor’s goals, the type of bond, and the issuer. Here are four key risk factors to consider:
1. Default and Credit Risk
Credit risk pertains to the issuer’s ability to repay the investor, influenced by economic conditions and financial health. Credit ratings from agencies like Moody’s and S&P Global help assess the issuer’s risk level.
Default risk specifically refers to the possibility of the issuer failing to make interest payments or repay the principal. Corporate bonds and high-yield bonds are more susceptible to default risk.
2. Inflation and Interest Rate Risk
Inflation can erode a bond’s purchasing power, while interest rate changes impact bond prices. Long-term government bonds and corporate bonds are more affected by interest rate risk.
3. Reinvestment Risk
Reinvestment risk arises when bond payments are reinvested at lower rates, reducing overall returns. Callable bonds and zero-coupon bonds are prone to reinvestment risk.
4. Liquidity Risk
Liquidity risk occurs when selling a bond below its market value due to low demand. High-yield bonds and mortgage-backed securities are more exposed to liquidity risk.
Bonds vs. Bond Funds: Different Risks
Investors have been turning to bond funds for diversification, professional management, and liquidity. While bond funds offer benefits, they also come with risks such as interest rate fluctuations and management risk.
Ultimately, investors must weigh the risks associated with bonds and bond funds to make informed decisions about their portfolio allocation.