Bonds might have their advantages to include providing a safer investment option as compared to stocks and other high-risk investments but this does not mean that they do not come with risks. All investments have risks. Some of these risks are even unique or limited to specific assets and securities. This article outlines and describes the major types of risks in bonds.
Types of Risks to Know Before Investing in Bonds
1. Credit or Default Risk
One of the major risks of investing in bonds is credit risk. Purchasing and owning a bond means purchasing a certificate of debt. The investor or bondholder is a debtholder. He or she exposes himself or herself to the possibility that the bond issuer will go into default before the issued bonds reach their maturity.
Corporate bonds are more susceptible to credit or default risk because they are not guaranteed by the full faith credit of most government bonds such as the Treasury bonds of the United States government. Furthermore, it is important to note that companies are exposed to macroeconomic factors that can affect their profitability and business interests.
Of course, government bonds are still susceptible to credit risk because countries are still exposed to different influences that can affect their economic growth. Avoiding or minimizing this risk requires investors to look into the credit ratings of bond issuers, the integrity and stability of their internal affairs, and their historical performance.
2. Market Risk
The financial markets do not provide guaranteed returns. Note the stock market and foreign exchange market are volatile. The bond market is less volatile but it is still responsive to external circumstances and other factors. The value of a particular bond can essentially fluctuate with changing market conditions and overall economic health.
Certain events affect the performance of bonds. For example, when the stock market is doing well, bonds tend to have poor performance. The value of bonds is also negatively affected by prolonged high inflation rates, the subsequent interest rate hikes of central banks, and economic downturns such as slowdowns and recessions.
Market risk is unavoidable but manageable. The best way to lessen exposure to this risk is to diversify investments outside bonds. Furthermore, when it comes to investing in bonds, proper research and purchasing bonds from different institutions operating in different environments can also minimize situation-specific market risk.
3. Interest Rate Risk
Another major risk of investing in bonds is the interest rate. Investors seeking to purchase bonds should familiarize themselves with the inverse relationship between bond prices and interest rates. Falling interest rates result in bond prices going up. Rising interest rates or rate hikes result in bond prices going down and overall depressed bond market.
The aforesaid inverse relationship exists because investors tend to purchase as many newer bonds as they could while interest rates are declining, thus increasing the demand for bonds which, in turn, increases bond prices. Rising interest rates decrease the demand for bonds, especially those that pay lower interest, thus decreasing their value.
4. Inflation Risk
Note that the stock market is also exposed to inflation risk. Persistent and prolonged high inflation rate makes things such as commodities and consumer goods expensive. Consumers have less purchasing power and this affects the profitability of companies. These companies also suffer further from increased business costs.
It is also important to note that inflation can lead to an economic slowdown marked by dampened business activities. In addition, to combat high inflation, central banks tend to raise interest rates, this dampening further business activities. A combination of high inflation rate and interest rate hikes can lead to stagflation, thereby affecting the bond market.
Bonds that provide lower returns than the average inflation rate also mean that their bondholders are losing the value of their investments. For example, if the average inflation for the next five years will be 5 percent while bonds have a 3 percent rate of return, the true rate of return for investors is -1 percent. Their bonds have lost their value.
5. Liquidity Risk
Remember that bonds are more liquid than stocks. However, bondholders are still susceptible to liquidity risk, especially when compared to holding cash or other investment options such as bank deposits and other money market instruments. Note that liquidity risk is higher in corporate bonds than in government bonds.
Different market situations can prevent bondholders from selling their bonds. For example, during economic slowdowns or when the bond market is not performing well while the stock market is on its bullish streak, these investors may have a hard time selling their bonds for cash as quickly as possible due to few buyers.
6. Callable Bond Risk
Note that callable bonds are bonds and fixed-income securities that allow the issuers to retain the right to redeem them at some point or retire them early before reaching the date of maturity. The principal is paid in full to the bondholders and the payment of interest is terminated. This right or privilege is also called the call provision.
Investors must be aware of the drawbacks and risks associated with purchasing and holding callable bonds. For example, have a large portion of callable bonds in a particular investment portfolio runs the risk of failing to meet long-term financial goals and objectives, as well as the risk of diminishing ongoing passive income stream from investment
Another example is when an individual depends on his or her portfolio of callable bonds to finance his or her regular expenses as part of his or her retirement plan. Once these bonds are redeemed prematurely by their issuers, this individual will lose his or her passive income stream while exposing him or her to the risks of having too much cash on hand.
A Note on The Types of Risks in Bond Investing
The aforementioned types of risk in bonds represent the general realities that come with bond investing. However, considering that there are different types of bonds, it is also important to underscore the fact that the level of risk varies across each type.
Government bonds have lower credit risk and market risk than corporate bonds. Bonds issued by corporations with high credit ratings also have lower default risk and liquidity risks than high-yield bonds or so-called junk bonds.
Choosing the most suitable types of bonds requires answering pertinent questions about investing aimed at determining general investment purpose and specific investment goals and objectives, risk profile, and preferred investment horizon.