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How to Determine the Risks Associated with Bonds

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As an investment, bonds are generally considered a lower risk than stocks. However, bonds come with risks of their own, and it is possible to lose money when investing in bonds.
Bond investors should be aware of the following types of risks associated with bonds:

·         Interest rate risk
·         Credit risk
·         Call risk
·         Inflation risk
·         Tax bracket related risks

Interest Rate Risk
Bonds have an inverse relationship to interest rates. If interest rates rise, the bond price goes down. While a bond’s interest rate is usually set when it is issued, if interest rates rise, the bond will become a less attractive investment in the secondary market. A secondary market means that a bond holder sells a bond to another individual, as opposed to the original issuer selling a bond to an investor. The price of the bond then decreases.

Credit Risk
Bonds represent obligations, and issuers sometimes default on their obligations. If an issuer defaults, any investment amount due to you can usually be decreased or lost. Certain bonds are riskier than others, depending on the quality of credit that backs the bond. Federal bonds are generally considered safe; the government is unlikely to default on its obligations. Bonds issued by state and local municipalities are also considered relatively safe in regards to credit concerns. Corporate bonds are riskier than federal or municipal bonds. For this reason, corporate bonds usually yield higher earnings. Moody’s Investors Service and Standard & Poor’s are rating agencies that rate the creditworthiness of a bond issuer. An AAA rating indicates an issuer with little or no credit risk. Ratings like “Ca,” “C,” “DD,” or “DDD” indicate a bond issuer in default or lacking creditworthiness. Bonds rated “BBB” or better are considered acceptable for investors who want to preserve their original investment.

Call Risk
The issuer of your bond may call it in early (prior to maturity). If your bond is called, you have to redeem it and may end up reinvesting the funds again at a lower rate. If an issuer calls a bond, it often intends to issue new bonds at a lower interest rate. You have also lost any future stream of income from bond interest payments.

Inflation Risk
Bonds are usually issued with a set interest rate and a set amount of principal that will be paid upon maturity. If inflation rises while you hold your bond, the value of your bond may decrease. Upon maturity, your purchasing power will have decreased if inflation has continued to rise.

Tax Bracket Related Risks
If you have invested in a tax exempt municipal bond and your tax bracket decreases, tax-exempt investing may no longer be advantageous for you. In this situation, taxable bonds might pose less risk.

Bond Risk Is Tied to Bond Maturity Length
The longer a bond is tied up before maturity, the more time there is for interest rates, default, inflation, or callability (the bond being called in) to affect the safety of your investment. Short term bonds generally have the least risk associated with them, though short term bonds will generally pay lower returns. Investors may need to weigh safety (shorter maturity period) against the chance of greater yields.

Bond maturity periods are designated as:

·         Short-term bonds: up to 5 years maturity
·         Intermediate bonds: between 5 to 12 years maturity
·         Long-term bonds: maturity of greater than 12 years

Bond Risk Is Tied to Bond Interest or Coupon Rate
A bond with a lower interest rate risks a greater swing (up or down) in bond price. While these potential losses (or gains) are only realized if the bond is sold before the maturity date, they do represent risk for the investor.

Bond Mutual Funds as a Strategy to Decrease Bond Risk
No investment is risk free, but bond funds offer a way to invest in bonds and let a manager make decisions about buying, selling, and portfolio composition. A bond fund is a mutual fund that consists of bond holdings that are chosen and managed by a fund manager.

The advantages:

·         Bond funds can be invested in with small amounts, so an investor with limited funds can access this investment vehicle. Bonds require larger investments.
·         Bond funds pay and reinvest dividends.
·         Investors benefit from the judgment of an experienced bond manager.

The disadvantages:

·         Bond fund holdings may include risky bonds.
·         Bond fund holdings with long maturities increase risk.
·         Bond fund holdings with variable interest rates increase risk.
·         Bond funds incur expenses and fees; these cover the management and expertise that directs the fund.

Further Resources

·         Ohio State University Fact Sheet on Bonds and Bond Risk:       http://ohioline.osu.edu/mm-fact/0005.html
·         The SIFMA Foundation for Investor Education Web site on Bond Risks:      http://www.pathtoinvesting.org/invchoices/bonds/bonds/bonds_071.htm
·         Corporate Research Project of Good Jobs First, Public Bonds Web site:            http://www.publicbonds.org/bond_basics/bond_basics.htm

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