There are many good reasons to buy bonds. They’re generally lower risk than stocks, pay interest and can have the potential for capital gains. Though bonds have long been considered a safe haven, investing in bonds is not a risk-free undertaking.
Interest Rate Risk
Bond prices are negatively correlated with interest rates. This means that when interest rates rise, bond prices fall and conversely when interest rates fall, bond prices rise. Interest rate risk is the danger that bondholders might rapidly sell off their positions in a certain bond or class of bonds to buy higher-yielding ones.
For example, Anne purchases a bond at par value that pays 5 per cent. Shortly after buying the bond, interest rates increase, and the broader market suddenly decides that 7 per cent is a more acceptable interest rate for that type of bond. This would force the price of Anne’s bond downwards in order to increase its effective yield. Anne would have to decide if she wanted to keep the bond until maturity and accept a lower-than-market interest rate or sell the bond at a discount or loss and purchase a higher-yielding one.
Inflation risk refers to the purchasing power of a bond. For example, if Bob purchases a bond yielding 5 per cent annually and inflation rises to 8 per cent, he would lose money on the investment because its purchasing power has been weakened.
This is the danger of having to reinvest proceeds of an investment or its interest coupons at a lower rate than they were previously earning. Until recently, people buying GICs over the last several decades might be familiar with this predicament.
For example, Joe’s $10,000 bond with a 5 per cent annual coupon pays him $500 of interest per year. When the bond matures, however, the prevailing interest rates are only 4 per cent, which means Joe’s newly reinvested bond would pay him just $400 per year.
When a bond is callable, it may be bought back by its issuer. This is done so the bond issuer can retire expensive debt and issue lower-cost, low-rate debt in its place. Call provisions are usually exercised when interest rates have fallen considerably since the bond was issued. Not all bonds have call provisions, so this risk can be avoided.
Liquidity risk refers to the inability to sell a bond and is most often prevalent among low-yielding corporate bonds. Often, this can be due to an individual corporation or their equity sector, such as energy, falling out of favor with investors. Much like a thinly traded stock, investors may have to take a lower price than expected on these bonds in order to sell them.
Credit or Default Risk
A bond certificate is a certificate of debt. The issuer of that debt is responsible for paying it back over time, plus interest. Default risk is the risk that a bond issuer won’t be able to meet those obligations. If a default occurs, a bondholder could lose some or all of their investment.
To minimize default risk, focus on buying investment-grade bonds. In Canada, the Federal government carries the highest credit rating, followed by provincial governments and large, stable corporations. There is, however a trade-off between risk and reward: the issuers with the highest credit ratings usually yield smaller coupons, as they generally don’t need to pay as much to attract buyers. Care must be taken to achieve the best balance of risk and reward in a portfolio.
The bond markets are several times larger than the stock markets and just as complicated to navigate. Always seek advice from a financial advisor to determine if an investment suits your needs and risk tolerance.