Are bonds a safe investment? What are the risks?

With the recent volatility in the stock market, it is no surprise that some have been looking for investments that offer safer returns.

Bonds appear to be one of these ‘safe’ investments that offer nice returns with not much risk. Considering the fact that over the past ten years corporate bonds and Treasuries have gained when blue chips lost, investing in bonds seems like a good bet.

And, of course, conventional investing wisdom tells us that bonds are “safe”. But is investing in bonds really safe?

What are Bonds?

As you probably know, bonds are basically IOUs. You lend money to corporations or to government entities (through Treasuries, domestic municipal bonds and foreign bonds). You receive regular income from interest payments, and when the bond matures, you receive the principal back. There are also bond funds that invest in a variety of different types of bonds, and provide you with relatively low cost returns. These bond funds are becoming popular due to the promise of income from an investment that is more stable than stocks. But just because there is less volatility with bonds, it doesn’t make them completely safe.

Risk of Investing in Bonds

Just like any investment, bonds come with the risk of loss. The corporation or government might default on the bond, meaning that you don’t get your principal back. Your only return comes from the interest that you have been paid thus far. Bonds that have higher returns generally come with higher risk. Bonds from emerging market countries, for example, come with a greater risk of default than U.S. Treasuries.

Bonds are rated according to their perceived risk, and highly rated corporate bonds are returning rather low rates right now because so many investors are demanding them to shore up their portfolios. Companies and countries with lower ratings have higher yields, but you are trading relative safety for these returns.

Another risk you run into when investing in bonds is interest-rate risk, which is the risk that you could be earning higher returns elsewhere. In most cases, you lock in a rate of return with bonds. You are tying up your money for a set period of time. While there is a secondary market for bonds, you are still likely to take some sort of a loss when you sell a bond, depending on the fees involved and what you sell the bond for. Bonds can be great if you think interest rates will fall, since you lock in better returns. However, if interest rates rise, you have committed money that can’t be used elsewhere for higher returns.

Default Risk

The first risk you have to consider is default risk. Remember: When you purchase a bond, you are purchasing someone else’s debt, whether it’s a government entity or a corporation. That means that there is always the chance that the borrower will be unable to repay the loan. If the borrower defaults, it means that you end up losing out on the amount that is still owed to you — plus the interest.

You can reduce your risk of default by choosing bonds that come from organizations that have relatively high credit ratings. Those bonds that are rated higher, such as US Treasuries and very stable corporations, come with a lower risk of default.

Of course, you pay for this safety with a lower yield. Bonds with better ratings are considered safer, and you are less likely to experience a default. As a result, you will receive a lower yield. If you are willing to brave a higher risk of default, you will receive a higher yield.

Liquidity Risk

Even though the bond market is fairly liquid, there is a level of liquidity risk when you invest in bonds. Being able to sell them when you want to requires a little bit of planning. You will probably have to turn to the secondary market if you want to sell a bond before its maturity rate.

While it’s usually possible to find willing buyers for government bonds — especially US government bonds — it can be a little trickier to find those willing to purchase some corporate bonds. And, if the bond you are trying to sell is a high risk bond, in a volatile environment, there is a chance that you will have even bigger liquidity issues. Unloading may be harder than you thought, and you might not be able to get the same value back.

Reinvestment Risk

When it is time to sell your bond or bond fund and reinvest the proceeds, you face another risk. What happens if you are forced to sell, and the new yield isn’t as generous as you would like. The bonds that are most prone to this risk are those that are callable. As interest rates fall, you run the risk of bond issuers recalling their bonds. You are forced to allow the bond to be redeemed, and when you try to reinvest, rates are lower, so you don’t see the same yield.

Many investors attempt to mitigate this risk by choosing bonds that aren’t callable, and that they can lock in for a longer period of time. If yields are higher, and you are afraid that they will drop, trying to purchase bonds without callable features can be very helpful.

Inflation Risk

You could run into inflation risk with bonds. Right now, yields are quite low, due to economic conditions. Indeed, bond yields on the “safest” investments are so low that there is some concern that they might not be able to keep pace with inflation — much less beat it — if prices begin to rise dramatically.

This is one of the risks that comes with low-yielding investments. Over time, you run the risk that you will actually see negative real returns. If inflation beats your yield, then your purchasing power is still eroded, and you could very well end up losing in real terms. When you purchase long-term bonds in a low-rate environment, like what we see now, you could miss out on higher yields later as inflation takes effect.

Safest Bonds

The safest bonds, in spite of warnings of a drop to the U.S. debt rating, remain U.S. Treasury Bonds. The U.S. has what is considered the most stable taxpayer base in the world, and that supports the idea of safety with U.S. Treasuries. However, as you might expect, Treasuries come with rather low yields — especially right now with so many people clammering for them. Indeed, 10-year bonds are barely keeping pace with inflation. (TIPS and I-bonds can help protect you from inflation.) But, even though the risk of default is generally expected to be small, the risk that the U.S. government will bail on its obligations is always there.

Are Bonds a Safe Investment?

While bonds can add some stability to your portfolio, and bond funds can provide income streams and bond diversification, it is important to realize that there is no guarantee of safety. There is always the risk of loss, and you should carefully consider your goals and your asset allocation to ensure that your portfolio isn’t too heavily weighted with bonds, restricting the growth you require to meet your future needs. Proper asset allocation remains the key to hedge your risk across multiple types of securities.