The Risks Unique to Bonds
As is the case with all investments, there is some degree of risk involved in bond investing. There are several types of risks that pertain specifically to bonds. Here are three of the most significant risks and how they affect the bond market.
Other less common risks in bond investments include call risk, which means the issuer can buy you out of your investment before maturity. That can happen when rates drop and they want to call in high interest bonds so they can issue new ones at the new lower rate. But risks like these are less common, especially in a period of stable or rising interest rates.
Credit Risk
This is the risk of default by the company issuing the bond, resulting in the loss of your principal investment. This is why bonds are rated, just like people looking for credit. Government bonds — at least in theory — don't have this risk and therefore need not be graded; they are simply safe investments. As a potential investor, you need to compare the risk and the yield, or return, you will get from different grades of bonds. If, for example, you will do almost as well with a high-grade tax-exempt municipal bond than you will do with a lower-grade taxable corporate bond, take the safer route and buy the municipal bond. Buying riskier bonds, or lower-grade bonds, is only worthwhile if you will potentially see returns big enough to merit taking that credit risk.
Interest-Rate Risk
If you are holding a bond to maturity, interest-rate risk is not terribly significant, since you will not be particularly affected by changing interest rates. However, if you are selling a bond, you need to concern yourself with the rate of interest that ties in with the yield of the bond. Essentially, the risk is that you will be stuck holding a long-term bond that pays less than the current interest rate, making it hard to sell and reinvest your capital.
Buy bonds based on your needs and financial situation. Plan to buy a particular bond and hold it to maturity. Don't be intimidated by a broker who asks, “But what if you need to sell the bond?” Buying just in case you need to sell is defensive buying, and you may regret it in the long run.
The longer the maturity of the bond, the more a change in yield will affect the price. You will better manage interest-rate risk by buying shorter maturities and rolling them over. However, if you are looking for higher returns over a longer period of time, you should go with the longer-term bond and hope you do not have to sell it.
Many financial brokers talk a great deal about the interest fluctuations on bonds. This is because they are in the business of buying and selling them. Many bond owners, however, tuck bonds away for years and enjoy the income generated. Therefore, before worrying greatly about the interest-rate fluctuations making your bond more or less valuable in the secondary market, decide on your plan. Are you buying bonds to sell them or to hold them to maturity? If you consider yourself financially sound and are simply looking to purchase a long-term bond for a future goal, then by all means go with your plan. Since the idea is to hold onto the bond until it matures, you will enjoy the higher yield. Even if you are forced to sell a fifteen-year bond twelve years toward maturity and you take a loss on the price, you will have still enjoyed higher yields than you would have with short-term bonds.
Income Risk
This is a double risk: first that should you sell, you won't get the full value (or par), and second that inflation will surpass the rate of income you are receiving from the bond (known as inflation risk). If you are reinvesting your interest income, you also will see less immediate income. However, you will be building your investments.
The best way to manage income risk is to stagger or ladder your bonds so that you can pick up the higher interest rates along the way. Inflation risk can be combated by simply re-evaluating your asset allocation and possibly moving to an investment that is higher than the inflation rate until it drops. If you already have an income-producing bond paying a rate of 3.9 percent, and inflation has gone up to 4.1 percent, you can reinvest the income in a higher-yield (perhaps slightly riskier) vehicle. An equity fund will more likely beat the inflation rate.
