As is the case with all investment instruments, bond investing can expose an investor to risks. Nevertheless, investors are able to enjoy a fairly steady stream of income or returns from bonds or use them as diversifying investments. A first-time investor must understand various bonds and the associated risks brought about by investing in them.
What Is Bond Risk?
Risks in bond investments are those that are associated with the possibility of money being lost. Although it is considered low risk when compared to stocks, bond investments carry risk from the beginning to the end. Interest rate changes, creditworthiness of the issuer, and the tracking of maturities are some of the various variables affecting the prices of bonds.
Types of Bond Risk
Hence, there is a must for these various bond risk sorts to be understood before one can take the final decision that an investment in a given bond is good for its investment strategy.
– Interest Rate Risk: This is the risk that rising interest rates will cause the price of bonds to fall. When rates go up, previously issued bonds with low coupon rates appear less attractive, which decreases their market price. Longer-term bonds are sensitive to interest rate changes. Why are some still choosing other financial instruments, even when bonds are offering higher interest rates?
– Default Risk (Credit Risk): This refers to the possibility that the bond issuer will default and thus not pay interest or repay the principal. Credit risk varies from issuer to issuer, and credit rating agencies assess it. Lower ratings carry higher credit risks.
– Inflation Risk: Inflation deteriorates the purchasing power of fixed interest income payments from bonds. In cases of sudden inflation, the real returns from a bond could turn negative in real terms, especially in longer maturities and low-yielding bonds.
– Liquidity Risk: Some bonds may sell only at a price less than what investors originally paid, so immediate liquidity may not be available. Increased risks associated with rarely traded or lesser-known entities raise the risk of such bonds.
– Call Risk: A given bond may be callable; therefore, an issuer can pay off a bond before reaching maturity. This usually happens when interest rates fall, allowing the issuer to refinance its loans at lower rates and compel investors to reinvest their funds in a less favorable environment.
– Reinvestment Risk: Reinvestment risks arise when interest or principal payments are reinvested at a lower rate than that on the original bond. This reduces total returns, especially in a falling interest rate environment.
– Duration Risk: The sensitivity of a bond to changes in interest rates is measured by its duration. Longer-duration bonds demonstrate more movement in market prices when interest rates fluctuate. Investors typically manage duration to reduce interest rate risk. In general, the longer the maturity of a bond, the higher its duration.
Managing Bond Risk
Investors can manage bond risk through diversification, research, and matching investment objectives with appropriate bond types. Diversifying across issuers, sectors, and maturities can reduce exposure to individual credit events or market conditions. Laddering bonds maturing at different intervals is another method to mitigate interest rate and reinvestment risk.
Beyond reviewing credit ratings and financial reports concerning bond issuers, investors can also discover whether issuers are likely to meet their obligations. Government and municipal bonds suit those seeking lower volatility, while corporate or high-yield bonds appeal to those seeking higher returns and willing to take on additional risk.
Conclusion
Bonds can be the greatest asset any investment portfolio can have, providing investors with the required income and stability. Not all risks are covered; bonds also carry risks. Hence, for first-time investors, knowing the bond risk types of bonds available is essential for developing a balanced strategy.