This third and final column on bonds is focused on understanding the risks that come with investing in bonds. While many investors think of stocks as the “risky” investment and bonds as the “safe” one, there are actually a number of risks that come with bond investments.
As I noted before, the longer the duration of your bond, the more volatile its value will be. A 30-year bond’s price will fluctuate much more than a 3-year bond’s price. When interest rates skyrocketed in 2022 and the rate on a 30-year government bond jumped from around 2% at the start of the year to nearly 4% at the end, 30-year bonds dropped in value by as much as 30%! Shorter-duration bonds dropped in value as well, but far less. Of course, you always have the option of holding your bond until it matures, but who wants to keep a bond that’s paying 2% for the next 20 years when you can buy a new one and earn 4%? This is called interest rate risk, because when new bonds pay higher interest than yours, your existing bond becomes less valuable.
A second risk of bonds is credit risk, which is the risk that the issuer of the bond will default and either not be able to issue the coupon payments or will be unable to pay back your investment at the end. As a bond investor, you get to choose your level of credit risk: government bonds are generally considered lowest risk, although this can actually vary depending on the issuer. Corporate (business) bonds are divided into either investment-grade bonds, typically believed to have less default risk, or junk bonds, which generally carry more default risk. Agencies like Moody’s, S&P and Fitch provide bond ratings based on how risky they believe a company’s bonds are, so investors can use those as a guideline when deciding how much risk to take on.
Reinvestment risk is a third risk that comes with bond investing. This particular risk applies only to investments in individual bonds, since bond funds reprice daily. Picture that you have five $25,000, 10-year bonds ($125,000 total), with each one paying you a coupon monthly at an annualized rate of 5%. In this scenario, you are earning a total of $6,250 in interest annually from your bonds. If your bonds mature and the new market rate is only 4%, your annual interest would drop to $5,000, which is $1,250 less than you were making before (of course, if interest rates increased instead, your new bonds would actually earn more!). Your cash flow is reduced. That is what reinvestment risk looks like.
Another factor that impacts risk is how you buy your bonds. There are two common ways of investing in bonds: buying individual bonds, or purchasing shares of a bond mutual fund/ETF. If you are buying an individual bond, it’s pretty simple: you’ve lent money in return for a consistent income stream and loan repayment at the end of a fixed period of time.
When you invest in a bond fund, there are hundreds or even thousands of bonds in the fund, each with its own rate and duration. Because of this diversification, credit risk is reduced: if one bond is defaulted on, it only represents a small fraction of your portfolio. However, interest-rate risk is more complex, since you don’t have the option to hold all of your bonds until they reach their date of maturity (end date). You are fully exposed to the changes in market value due to daily changes in interest rates.
At the end of the day, bonds come in many different varieties, and when properly used can enhance an investment portfolio by bringing in consistent cash flows and reducing risk as compared to equities and various other investments.
How ever you choose to use bonds in your portfolio, invest smartly and invest well!
Larry Sidney is a Zephyr Cove-based Investment Advisor Representative. Information is found at https://palisadeinvestments.com/ or by calling 775-299-4600 x702. This is not a solicitation to buy or sell securities. Clients may hold positions mentioned in this article. Past Performance does not guarantee future results. Consult your financial advisor before purchasing any security.