The Risks of Investing in Bonds

Investing in bonds is not without risks. Every investment in bonds carry some risks, although the degree of the same varies with the type of debt and the issuer.

The following list describes the potential risks that the bondholders encounter:

  • The interest on the bond might not be paid (credit and default risk)
  • The principal might not be repaid
  • The price of the bond might decline to less than the purchase price before maturity (Interest-rate risk)
  • Interest rates might fall resulting in less interest income when the proceeds received (interest and principal) are reinvested (reinvestment-rate risk)
  • Inflation might rise causing an erosion of purchasing power of the interest and principal payments received (inflation risk).
  • Bonds may be called before maturity

You should be conscious of how different types of risks affect bond investments.

The interest-rate risks are those which affect interest rates and cause the prices of bonds in the market to decline. The interest-rate risk is referred to changes in the rates of interests in the market, which have a direct effect in the bond prices. The prices of fixed-income securities change inversely with the changes of interest rates.

During the high period of the interest rates investors that own fixed-income securities experiment losses with their bonds in the market because the new investors in these type of bonds wish for a competitive yield.

Equally, in low periods of interest rates prices of existing fixed-income securities raise. To more maturity time greater the potential risk of interests.

Investors can minimize the risk of interest rates of their portfolio with different maturities by, reducing maturities and staggering their bond investment maturities. As an investor you minimize risks of interest rates of the bonds if you keep them until maturity.

The credit risk (default risk) is the risk by which the issuer could not be able to pay the interests and repay the principal in the pre-established dates. The credit risk is a function of the credit trust of the issuer of the debt. The creditworthiness refers to the ability that the issuer has in making scheduled payments and repaying the principal at maturity date. The credit risk varies with bond issuers.

US Treasury issues carry virtually no risk of default because of the full faith and credit of the US Government guarantees interest and principal payments.

US Agency debt has a slightly increased risk of default depending on the financial strength of the issuer. Not all US Government agencies have the backing of the US Government.

Bonds issued by state and local governments depend on the financial health of the particular issuer and its ability to raise revenue. For corporate issuers credit risks are linked to the strength of the issuing companies’ balance sheets, income statements, and earning capacities.

For example, the Enron bonds fell when Enron declared themselves bankrupt. The restructured Enron Corporation fixed with their creditors, paying them around $0.14 per dollar. For bondholders this arrangement was of $140 for every $1000 face value of each bond.