Although bonds are a great tool to generate income, and are widely considered to be a safe investment especially when compared to the risks of investing in stocks, investors need to be aware of some of the potential challenges to holding corporate and/or government bonds.
The greatest risks posed to bond investors are:
- Interest Rate Risk
- Reinvestment Risk
- Inflation Risk
- Default Risk
- Liquidity Risk
Interest Rate Risk
Interest rates and bond prices enjoy an inverse relationship. As interest rates fall, the price of bonds trading in the marketplace generally rises. Conversely, when interest rates rise, the price of bonds is likely to fall.
Another challenge facing bond investors is something called reinvestment risk. This is the risk of having to reinvest investment proceeds at a rate that is lower than the funds were previously earning. Over time, this reinvestment risk can have an adverse effect on an investor’s investment returns.
If the cost of living and inflation increase dramatically, and at a faster rate than income investment, investors will see their purchasing power erode and may actually achieve a negative rate of return.
When investors purchase bonds, they are actually purchasing a certificate of debt. This is money that is borrowed and must be repaid by the company over time, with interest. The risk with this is that corporate bonds are not guaranteed. Instead, these bonds depend greatly on whether the company is able to repay that debt.
Although there is almost always a market ready to purchase government bonds, corporate bonds are sometimes entirely different. There is a risk that an investor might not be able to sell his or her corporate bonds, or may be forced to take a much lower price than expected to sell the bond.
Accounting For Bond Risks
Aside from interest rate risk, which is the most well-known of risks in the bond market, reinvestment, default, and liquidity risk should also be closely considered when choosing to pursue a bond investment.
In an effort to protect themselves, investors can can learn more about the risk of different bonds from a credit rating agency like DBRS, Fitch, Moody’s or Standard & Poor’s. These agencies rate the issuer’s ability, in the opinion of the agency, to make regular interest payments and to pay investors back when the bond matures.
Additionally, investors should read investment reviews and adopt a strategy that chooses a mix of bonds with different features. This increases the odds that some of your bonds will perform well at times when others do not. Investors should consider buying a mix of government and corporate bonds that contribute to a well-built portfolio, and account for financial goals and tolerance for risk.