3 Risks to Consider Before You Buy a Bond

by Dan Wiener | May 8, 2013 7:30 am

3 Risks to Consider Before You Buy a Bond

After more than three decades of booming bond markets, you could be forgiven for thinking that bonds are about as risk-free as you can get.

But you’d also be wrong.

Bonds are actually riskier investments today than they’ve been in quite some time. Let me explain.

Default Risk

Interest-rate risk (the risk that a bond’s price will fall if interest rates rise) is not the only risk that investors face. Another key risk is that the bond issuer might be unable to pay back the money it borrowed — called either credit risk or default risk. The bond market isn’t just Treasuries, as you know. Many different entities need to borrow money, and not every one of them is equally likely to be able to meet their obligations.

Bonds issued by the U.S. Treasury are often called “risk-free” because investors see the U.S. government’s default risk as minimal. The government can always raise taxes or print money to cover its obligations. Of course, Treasury securities are still subject to interest-rate risk, so they really aren’t risk-free unless you hold them to maturity.

Bonds issued by corporations generally carry a higher risk of defaulting. When lending to an entity with greater default risk, lenders (the folks like us buying the bonds) want to be compensated for this risk, usually in the form of a higher yield.

Inflation Risk

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Another risk, hidden yet insidious, is inflation risk, or the risk that a bond’s return might not keep up with inflation.

As you know, inflation is a broad increase in the prices of goods and services. One outcome of inflation is that your purchasing power decreases — so $100 in the future won’t be able to buy you as much as $100 can today.

Inflation is a cost to all investors. Say you make an investment and it returns 5%, but over that time period inflation runs 2%. Your nominal return might have been 5%, but your real return after factoring in inflation is only 3% (real return = nominal return – inflation).

If inflation affects all investors, why should bond investors be particularly concerned? After all, you never hear about stocks having inflation risk (or at least, not too often).

Let’s go back to the fixed-income aspect of bonds. Focus on the word “fixed.” When you buy a bond, you are locking in a fixed level of return (assuming you hold the bond to maturity). But inflation can change over time. If you buy a bond with a 3% yield and inflation is 1%, you would expect a real return of 2%. However, what if inflation suddenly rises from 1% to 4%? Now your real return has gone negative — from 2% to -1%. On a real basis, you’ve actually lost purchasing power, despite earning a 3% yield.

Since one goal of investing is to not only maintain but also improve our ability to consume in the future, inflation is not to be taken lightly.

Reinvestment Risk

A final risk that often goes unnoticed but has a big impact is reinvestment risk, or the risk that, when your bond matures and your principal is returned to you, the only options available for reinvesting the money pay a lower yield. For bond investors, this occurs when interest rates are on the decline.

Suppose you buy a bond that matures in two years and yields 4%. After two years, the borrower returns the money you lent, and you want to invest in another two-year bond. But now interest rates have declined, and two-year bonds yield 2%. That’s reinvestment risk. You would have been better off buying a bond with a longer maturity.

This reinvestment risk applies not just to the return of principal but also to any interest you might receive during the life of the bond. Bond investors seem to love it when interest rates are falling because the prices on their bonds rise, as they’ve done for more than 30 years. But they should be disappointed when it comes time to reinvest that money.

That’s the silver lining to a rising interest-rate environment: You get the opportunity to invest in higher-yielding options as your bonds mature.

Why You Shouldn’t Bolt From Bonds

Like many financial advisers, I have been early in warning that interest rates are bound to rise, though it looks as if the market might finally be catching on. But this doesn’t mean you need to go out and dump all of your bonds or bond funds. Some are going to remain a good diversifier for your portfolio. Bond investing involves a lot more than yield alone — structure, quality and the experience and discipline of the managers who run bond funds all matter.

Also, total return isn’t the only reason to hold bonds. Bonds serve as a diversifying asset and help stabilize portfolios during stormy markets. That 2% yield might not look attractive with stocks generating 10% gains, but in a down market, even 2% looks awfully comforting.

Despite the current low-yield environment, if you want to generate income or to manage your portfolio’s risk, bonds remain a critical piece of that strategy.

Editor Dan Wiener and Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors[1], a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds.

Endnotes:
  1. The Independent Adviser for Vanguard Investors: http://investorplace.com/order/?sid=WRC137

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