Understanding Dangers in Fixed-Income Investing

There's no such thing as a sure thing, even in the bond world

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Bonds are among the safest investments in the world. But that hardly means that they’re risk-free. Here’s a look at some of the dangers inherent in fixed-income investing.

  • Inflation Risk: Because of their relative safety, bonds tend not to offer extraordinarily high returns. That makes them particularly vulnerable when inflation rises.

    Imagine, for example, that you buy a Treasury bond that pays interest of 3.32%. That’s about as safe an investment as you can find. As long as you hold the bond until maturity and the U.S. government doesn’t collapse, nothing can go wrong….unless inflation climbs. If the rate of inflation rises to, say, 4 percent, your investment is not “keeping up with inflation.” In fact, you’d be “losing” 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 worthless.

    Note: there are exceptions to this rule. For example, the Treasury Department also sells an investment vehicle called Treasury Inflation-Protected Securities.

  • Interest rate risk: Bond prices have an inverse relationship to interest rates. When one rises, the other falls.

    If you have to 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 fluctuate with interest rates. Calculating the vulnerability of any individual bond to a rate shift involves an enormously complex concept called duration. But average 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 the 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.

  • Default Risk: A bond is nothing more than a promise to repay the debt holder. And promises are made to be broken. Corporations go bankrupt. Cities and states default on muni bonds. Things happen...and default is the worst thing that can happen to a bondholder.

    There are two things to remember about default risk.

    First, you don’t need to weigh the risk yourself. Credit ratings agencies such as Moody’s do that. In fact, 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 default is seen as extremely unlikely, is at the top.

    Second, if you’re buying 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. It’s inconceivable that the folks who actually print the money will default on their debt.

  • Downgrade Risk: Sometimes you buy a bond with a high rating, only to find that Wall Street later sours on the issue. That’s downgrade risk.

    If the credit rating agencies such as Standard & Poor’s and Moody’s 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 complicated by the next item on the list, liquidity risk.

  • Liquidity risk: The market for bonds is considerably thinner than for stock. The simple truth is that 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 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.

  • Reinvestment Risk: Many corporate bonds are callable. What that means is 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 he had locked in an interest rate and a level of safety.

    For example, suppose you had a nice, safe Aaa-rated corporate bond that paid you 4% a year. Then 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. If rates have fallen to 2%, you’re not going to get 4% with a nice, safe new Aaa-rated bond.

  • Rip-off Risk: Finally, in the bond market there’s always the risk of getting ripped off. Unlike the stock market, where prices and transactions are transparent, most of the bond market remains a dark hole.

    There are exceptions. And average investors should stick to doing business in those 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 itself or some other reputable institution. Even buying new issues of corporate or muni debt isn’t all that bad.

    But the secondary market for individual bonds is no place for smaller 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.

    But you’d be hard-pressed to find any scrupulous financial advisor who would recommend that your average investor venture in to the secondary market on his own.