The Risk of Bonds

by Miranda Marquit on November 1, 2012

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In times of economic uncertainty and turmoil, many investors turn to bonds. The assumption is that bonds are only a little riskier than cash — but provide higher returns.

Even though many consider bonds “safe,” there are some risks involved. If you aren’t careful, you could find yourself in a less-than-desirable position associated with your bond investments. While bonds can be helpful tools, and while bonds can be solid additions to your investment portfolio, make sure you understand the risks that can come with them.

Default Risk

The first risk you have to consider is default risk. Remember: When you purchase a bond, you are purchasing someone else’s debt, whether it’s a government entity or a corporation. That means that there is always the chance that the borrower will be unable to repay the loan. If the borrower defaults, it means that you end up losing out on the amount that is still owed to you — plus the interest.

You can reduce your risk of default by choosing bonds that come from organizations that have relatively high credit ratings. Those bonds that are rated higher, such as US Treasuries and very stable corporations, come with a lower risk of default.

Of course, you pay for this safety with a lower yield. Bonds with better ratings are considered safer, and you are less likely to experience a default. As a result, you will receive a lower yield. If you are willing to brave a higher risk of default, you will receive a higher yield.

Related: Hedging Risk Exposure

Liquidity Risk

Even though the bond market is fairly liquid, there is a level of liquidity risk when you invest in bonds. Being able to sell them when you want to requires a little bit of planning. You will probably have to turn to the secondary market if you want to sell a bond before its maturity rate.

While it’s usually possible to find willing buyers for government bonds — especially US government bonds — it can be a little trickier to find those willing to purchase some corporate bonds. And, if the bond you are trying to sell is a high risk bond, in a volatile environment, there is a chance that you will have even bigger liquidity issues. Unloading may be harder than you thought, and you might not be able to get the same value back.

Reinvestment Risk

When it is time to sell your bond or bond fund and reinvest the proceeds, you face another risk. What happens if you are forced to sell, and the new yield isn’t as generous as you would like. The bonds that are most prone to this risk are those that are callable. As interest rates fall, you run the risk of bond issuers recalling their bonds. You are forced to allow the bond to be redeemed, and when you try to reinvest, rates are lower, so you don’t see the same yield.

Many investors attempt to mitigate this risk by choosing bonds that aren’t callable, and that they can lock in for a longer period of time. If yields are higher, and you are afraid that they will drop, trying to purchase bonds without callable features can be very helpful.

Inflation Risk

You could run into inflation risk with bonds. Right now, yields are quite low, due to economic conditions. Indeed, bond yields on the “safest” investments are so low that there is some concern that they might not be able to keep pace with inflation — much less beat it — if prices begin to rise dramatically.

This is one of the risks that comes with low-yielding investments. Over time, you run the risk that you will actually see negative real returns. If inflation beats your yield, then your purchasing power is still eroded, and you could very well end up losing in real terms. When you purchase long-term bonds in a low-rate environment, like what we see now, you could miss out on higher yields later as inflation takes effect.

Related:  Understanding and Hedging Interest Rate Risk

Bottom Line

There is risk with any investment. Even the “safe” investments carry the risk of loss. Bonds have their own risks, and it’s important that you understand them as you build your investment portfolio.

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This post was written by...

– who has written 12 posts on Excess Return.

Miranda is a freelance contributor to several investing and personal finance web sites. She also writes for her own blog, Planting Money Seeds.

{ 1 comment… read it below or add one }

Ken Faulkenberry - Arbor Investment Planner November 1, 2012 at 4:27 pm

You have outlined 4 important bond risks. I would like to add interest rate risk to your list. Bond prices rise when interest rate yields fall, and bond prices fall when interest rate yields rise. Bond prices are at historic highs and bond yields are at historic lows. In other words, if you own bonds you are accepting record high risks and record low rewards.

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