While bonds are among the safest investments in the world, fixed-income investing carries some dangers, with risks running the gamut from inflation to recalls. Here's a look at some of the inherent downsides that investors should be aware of and what, if anything, they can do about them.
Because of their relative safety, bonds tend not to offer extraordinarily high returns. That, along with the fixed nature of their interest payments, makes them particularly vulnerable when inflation hits. Imagine, for example, that you buy a U.S. Treasury bond that pays 3.32%. Given the stability of the U.S. government, that's one of the safest investments you can find—unless the rate of inflation rises to, say, 4%.
If that happens, your investment income is not keeping up with inflation. You'd lose money because the value of the cash you invested in the bond is declining. You'll get your principal back when the bond matures, but it will be worth less. Its buying power will have declined.
There are ways around this. The Treasury Department also sells bonds called Treasury Inflation-Protected Securities (TIPS). The principal value of TIPS adjusts up and down based on inflation as measured by the Consumer Price Index (CPI). The rate of return investors receive reflects the adjusted principal.
Interest Rate Risk
Bond prices have an inverse relationship to interest rates. When one rises, the other falls. If you sell a bond before it matures, the price you can fetch will be based on the interest rate environment at the time of the sale. In other words, if rates have risen since you "locked-in" your return, the price of the security will fall.
All bonds' prices fluctuate with interest rates. Calculating the vulnerability of any individual bond to a rate shift involves a complex concept called duration. But typical retail investors need to know only two things about interest rate risk.
First, if you hold a security until maturity, interest rate risk is not a factor. You'll get back your entire principal upon maturity. Second, zero-coupon investments, which make all their interest payments when the bond matures, are the most vulnerable to interest rate swings.
A bond is nothing more than a promise to repay the debt holder. However, corporations go bankrupt, and cities and states default on municipal bonds. Things happen, and defaulting is the worst thing that can happen to a bondholder. Not only is your income stream gone, but your initial investment is gone, too. At best, you'll get back a portion of your principal.
However, you don't need to weigh the risk yourself. Credit rating agencies such as Moody's and Standard & Poor's do that. Still, these bond credit ratings are nothing more than a default scale. Junk bonds, which have the highest default risk, are at the bottom of the scale. AAA-rated corporate debt, where defaulting is seen as extremely unlikely, is at the top.
Also, if you buy U.S. government debt, your default risk is nonexistent. The debt issues sold by the Treasury Department are guaranteed by the full faith and credit of the federal government. Although it's possible in a doomsday scenario that the government might be unable to pay its debts, it is unlikely to happen.
If the credit rating agencies lower their ratings on a bond, the price of those bonds will fall. That can hurt an investor who has to sell a bond before maturity. And downgrade risk is further complicated by liquidity risk.
The market for bonds is considerably thinner than for stock. When a bond is sold on the secondary market, there's not always a buyer. Liquidity risk describes the danger that when you need to sell a bond, you won't be able to.
Liquidity risk is nonexistent for U.S. government debt. And shares in a bond fund can always be sold. But if you hold any other type of debt, you may find it difficult to sell.
Many corporate bonds are callable. This means that the bond issuer reserves the right to "call" the bond before maturity and pay off the debt. That can lead to reinvestment risk. Issuers tend to call bonds when interest rates fall. That can be a disaster for an investor who thought they had locked in an interest rate and a level of safety.
For example, suppose you had a safe AAA-rated corporate bond that paid you 4% a year. Then, interest rates fall to 2%. Your bond gets called. You'll get back your principal, but you won't be able to find a new, comparable bond in which to invest that principal.
You can still find a safe new AAA-rated bond, but if rates are now at 2%, it won't be paying out 4%. You'll have to go with lower-rated and riskier debt to get that return. Or, you can pay a premium for an older bond that still offers that rate.
There’s always the risk of getting ripped off in the bond market. Unlike the stock market, where prices and transactions are transparent, most of the bond market remains a dark hole. That's because most bonds are not traded in the secondary market via exchanges like the New York Stock Exchange. Rather, bonds are traded over the counter (OTC).
An OTC trade is executed directly between two parties, so it is not subject to the rules of an exchange. Without oversight or adequate information, trading OTC can be tricky for individual investors.
Things are better than they once were. The TRACE (Trade Reporting and Compliance Engine) system has done wonders to provide individual bond investors with the information they need to make informed investing decisions. Even so, average investors should stick to doing business in certain areas.
For example, the bond fund world is pretty transparent. It only takes a tiny bit of research to determine if there is a load—sales commission—on a fund. And it only takes another few seconds to determine if that load is something you're willing to pay. Buying government debt is a low-risk activity as long as you deal with the government or a reputable financial institution. Buying new issues of corporate or municipal debt is relatively safe as well.