Risks of Bonds

Risks of Bonds

February 05, 2024

As mentioned previously bonds have risks that should be understood. Here are a few of the most common risks in bond investing.

One of the most relevant risks is how interest rate changes effect this investment. In last week’s hypothetical example, the market rate for bonds was 5%. What would happen to the value of that bond if the market rate for interest rates changes to 6% shortly after that bond was purchased? Because investors could now demand 6% instead of 5%, the 5% bond now becomes less valuable. If the investor wanted to sell it to another investor, they are now selling a bond that has an interest rate below current market rates. Without doing the specific calculations, in theory, the bond would be sold to another investor in the marketplace at a discount rather than the full $100 they bought it for; it would sell for possibly $96 or $97. This is the interest rate risk that bond investors face. This has been particularly relevant in the last few years as interest rates have increased rapidly.

Another common bond risk that is related to interest rates is re-investment risk. This is the risk of no longer being able to re-invest your investment proceeds at the same rate or a higher rate. To illustrate this, suppose for a second that interest rates are declining rather than rising is they did in the last example. The 5% bond has matured, except that now market rates have declined to 4%. If the investor wishes to re-invest their bond proceeds into another bond, they will only be able to do so at a less appealing 4% rather than the previous 5%. This shows that re-investment risk is simply no longer being able to re-invest at the same interest rate as you previously did.

Lastly, understanding credit/default risk is important. When an issuer sells bonds, in theory there is some level of risk that the company will be unable to pay the investor the promised interest and principal. How likely that is to come to reality is based on the credit rating that the bond carries. The higher the credit rating, the more likely that the bond will be paid back. Rates can change over time so it important to be aware of them for safety. Lastly, there is a belief in the investment world that bonds issued by the US government are credit risk free. The reason basic reason behind this is that the if the US government always has the ability to raise taxes to pay their bills if needed.

Bonds A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer.