Risks of Bonds


Bonds are commonly considered to be a very low-risk investment, but it is inaccurate to say they carry no risk at all. Here is what you need to know about the risks associated with bonds.Bonds are commonly considered to be a very low-risk investment. Many people even consider them to be completely free of risk — but although they are much less risky than certain other investments, such as stocks, it is inaccurate to say they carry no risk at all. Here is what you need to know about the risks associated with bonds:

Inflation Risk

The interest payments for bonds are fixed, which means that inflation can decrease their value.

“On the other hand,” according to CNN Money Essentials, “bonds are a classic deflation hedge; deflation increases the value of the dollars that bond investors get paid.”

Interest Rate Risk

The price of bonds is inversely related to interest rates. So you need to keep an eye on the outlook for the rising interest rate to determine what may happen with your bonds.

“When rates rise, bond prices fall because new bonds are issued that pay higher coupons, making the older, lower-yielding bonds less attractive,” according to CNN Money Essentials. “Conversely, bond prices rise when interest rates fall because the higher payouts on the old bonds look more attractive relative to the lower rates offered on newer ones.”

If you don’t sell the bond early, and instead wait until it reaches its full maturity, then you don’t need to worry about price fluctuations that result from the changing interest rate. After the bond matures, you get the full face value.

Credit Risk

It is possible that the bond issuer will not be able to make payments on time or, in the worst-case scenario, won’t be able to make them at all. This depends on the type of bond you own and the security and financial position of the bond issuer.

“That is a pretty low risk if the entity is the U.S. government, but can be a high one if the bond was issued by a company, city or government entity that is in trouble — for an example, think about the problems that Detroit and Puerto Rico have had, or consider a small energy company that needs oil to trade at $50 to make loan repayments,” according to Jill Schlesinger for Time.com Money.

These are the main types of risks involved with bonds, but there are others that you should be aware of. Call risk involves the fact that some bond issuers reserve the right to “call” their bonds before the maturity date, which means that the people holding the bonds don’t get the full value they would have had at maturity. There is also liquidity risk, which is  a factor if you decide to purchase junk or municipal bonds, which are more liquid than Treasury bonds.

“Chances are that rates will rise in the coming months and years,” states Schlesinger. “That does not mean that you should avoid bonds altogether, but you may want to be careful about the types of bonds that you put inside your portfolio. If you’re not just using a broad-based bond index fund, stick to shorter-duration and higher-quality bonds, which can still have a stabilizing effect on a diversified portfolio over time.”

So, if you keep in mind these risks and how they impact different bond types, you will be able to weigh the risks and rewards of potential bonds. As always, talking to your financial adviser is the best way to ensure that your investment portfolio has the right balance of safe and risky investments.

 

Related Articles

Leave a Reply