Updated August 8, 2019 Investing in bonds definitely has risks, contrary to what many investors think. Just what are the risk of bond investments?
They include interest rate risk, default risk, inflation risk, call risk and economic risk. The fact that bonds are used to offset risk from stocks, and the very long bull market in bonds have led most investors to think that bonds have no risk.
Not only this, but bonds are a popular income investment for the increasing population of older retirees who lean only toward very traditional investing methods.
In this post, I’ll cover the risks of bonds. While I am an Accredited Financial Counselor®, I write mostly based on what I’ve learned from almost 40 years of investing in just about everything.
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Inflation Risk for Bonds Investors
Almost all bonds have inflation risk. I learned this firsthand in the early 1980’s runaway inflation days when my dad was able to buy municipal bonds for 50 cents on the dollar.
This means investors on the other side of his bond purchases were selling those same bonds at 50 cents on the dollar.
Now that is risk. Ouch! Here’s what happens with inflation and why it hurts bonds so badly in two ways.
- Income from bonds loses purchasing power as inflation occurs or rises.
- And the value of the bonds decreases.
Remember, a decline in the value of an investment creates a decline in net worth even when the investment is not sold.
Plus, there will be an investment loss if the bond investor needs to sell the bonds after such a decline, so inflation bond risk needs to be carefully understood before investing in bonds.
In the video below I talk about inflation risk from bonds in point #1.
Real Returns from Bonds
The yield an investor gets after deducting inflation is called the real return. This tells us a lot, right? Even if a bond has a 7% yield and inflation rises to even the historical average of around 3%, the real return is only 4%.
If taxes are owed on that bond income, an investor could potentially knock off another percent or two. And don’t forget to consider any wealth management and (or) fund fees, too, offsetting the yield even more.
Bond Risk from Rising Interest Rates
When interest rates rise, the value of bonds decreases. And the longer the duration of the bonds, the more the bonds decrease in value since investors are locked into lower yields for longer than they would be with shorter term bonds.
This is logical, as most investing is. No investor wants to hold lower yielding bonds when they can get higher yields from new bonds.
Credit Risk from Bond Investing
Bonds are subject to company risk, like AT&T, for example, or entity risk, such as a government or municipality.
Municipalities that issue municipal bonds go under at times, for example. Fear of municipalities going under were also a factor in driving down the price of the municipal bonds my dad bought that were mentioned earlier.
There was a bad recession in the early 1980’s. Investors feared that municipalities would go broke. My dad bought a cowboy hat, got in his very used Mercedes (with which he had a love hate relationship) and drove to Texas to check out many of the municipalities to assess if the risk was overblown.
And he diversified among the municipalities to lower credit default risk. Also, global bonds are subject to the risk of a country going under. And companies do go bankrupt on occasion.
One important risk lowering factor for bond investors is that bond holders do get their money back before stock investors in the event of liquidation, making them slightly less risky.
Fortunately, there are ratings for most corporate and entity bonds that income investors and wealth managers use to evaluate the risk of bonds or bond funds.
Bond Risk from Cycles
It’s hard to imagine because bonds are considered stodgy, but much like stocks (as in the image below), factors can drive bonds to overvaluations that must correct back to normal pricing.
The problem is that before going back to normal pricing, an investment must decline, usually significantly, in value first.
In other words, if the price of an investment has risen far above the historical average price, it usually drops back down way below the average price before it works its way back to the average price.
This is called mean reversion. And bond prices are pulled back to the norm for comparable risk assets based on yield. Stocks do this and bonds do this, too. These are called cycles. And they pose risk to unprepared investors.
For example, in the late 1980’s high yield bonds became overvalued due to the rise in popularity as investors tolerated higher risk for higher yield. Unlike today, there was a lot of hype around high yield bonds at the time.
This was after a guy named Michael Milken, who later went to prison, structured mergers and acquisitions through risky high yield bonds while at Drexel Burnham Lambert Inc.
Drexel Burnham Lambert was a highly regarded investment bank that, as a result, went into bankruptcy reminding me that on rare occasions financial firms fail. Investors lost a lot of money.
I still remember the day my dad called and said he thought high yield bonds were about to fall and suggested I assess our investment in a high yield global bond fund.
He was right, again. I was fortunate to have learned from him. It inspires my writing here, so thanks for tolerating my references.
So, bonds do go through cycles when they decline in value as an entirety, mostly due to interest rates, which are a factor of the economy.
But the good news is that bond risk from an overall market decline happens much less often than stock market declines. This is because interest rate cycles tend to last for many years, if not decades.
It’s hard to imagine that in the early 1980’s the Prime interest rate was almost 20%! These days I’m excited to get over 2% for our money market accounts.
U. S. Treasury Bonds for Lower Risk
U.S. Treasury bonds can behave completely differently than higher risk bonds. In times of increased financial turmoil, higher risk bonds drop.
They have have leverage, which can lead to trouble during hard economic times. But U.S. Treasury bonds are considered the safest investment other than cash or cash equivalents.
This is why they almost always increase in value when stocks decline. (See the chart lower in this post.) And this is why many investors are unaware of the risks of bonds: There is a general perception that bonds are a “safe investment” that will never go down.
But there is a big difference between a safe investment and an investment that won’t go down.
While it’s unlikely Treasury bonds will have credit problems (we just print more money-yikes!), Treasuries are still subject to interest rate risk just like other bonds are. Treasury bonds rise and fall in value in relation to the economy, or more aptly put, economic “expectations”.
Treasury Bonds in 2008
The past provides valuable information for proactive investors who choose to use it. So let’s see how Treasury bonds did during 2008, which was in the midst of the financial crisis and related bear market.
We do this by checking the performance of a fund (Exchange Traded Fund, or “ETF”) that represents Treasury bonds in 2008 because we have reliable data from this. Since TLT is a well established ETF which represents the 20+ year Treasury Bond, we’ll use it.
For example, TLT had a positive return of 33.76% in 2008, but TLT had a negative return of 21.53 in 2009. (1.) This demonstrates the need for either a well diversified portfolio OR use of tactical investment strategies that ease out of overvalued assets and into undervalued assets to lower risk while building wealth.
You can see in the chart I made below how bonds went up when stocks went down and vice versa from past bear markets in stocks.
The two years between 1969 and 2018 when both stocks (S&P 500 index) and the Treasury bonds went down are shown in red. (Feel free to use this chart with a link to this post. It was not easy data to find!) (2.)
Call Risk for Bonds
Many bonds have call features. This means that if interest rates decline, the company or entity that issued the bonds can call them from the bond holder. In other words, you don’t get to keep the bonds.
You’ll get paid the face value or an amount close to it. Like most investing, this makes perfect sense; the companies that issued the bonds can issue new bonds at lower interest rates.
This may seem unimportant. But bonds being called is a risk of bond investing since the higher interest rate bonds can be lost.
Then the investor is left with cash that cannot be invested again at the higher interest rates that existed when the bond was bought.
This can present a real problem for investors living off investments that are heavily invested in bonds.
For this reason, it’s important to note the call features if you buy individual bonds. Most bond investing done by individual investors is done through bond funds nowadays. Baby bonds have recently risen in popularity among savvy income investors who buy individual bonds.
In researching baby bonds recently as a potential investment to increase short term investment income, I noticed the call features were clearly indicated and easy to consider.
I experienced bond calls when the municipal bonds my dad bought in the early 1980’s were called away. But many of them were not called away for a decade, and the bonds were yielding up to 25% tax free.
This single investment move piqued my interest in investing from seeing how buying all those bonds cheaply completely changed my parent’s financial situation. I have been interested in investing ever since then.
I think everyone should be enthralled with investing, too, since it determines the quality of our lives only second to health. And investing well can often improve health, too, from being able to afford things that promote good health.
Risks of Bonds Summary
The scary thing is that many investors think bonds are completely safe. This misunderstanding increases risk simply from lack of awareness.
The good thing about bond investing is that the income should continue to flow into your investment accounts even if bonds drop in value. And Treasury bonds almost always go up when stocks go down, as in 2008.
The bad thing about bond investing is that the income is usually depleted from rising inflation. Plus, net worth will drop from the decline in the value of the bonds.
This is why it’s important to begin with an overall wealth plan to decide how much investment risk you want. Yep, you get to choose how much risk you want in your investment portfolio, so choose your risk level wisely.
We looked beyond stocks and bonds to add diversified income streams instead of living off investments completely after stumbling upon early retirement.
The best place to start is with my Ultimate Wealth Plan. You can get it here now.
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Author: Camille Gaines – About Sources: 1.ETF’s up in 2008 – https://www.morningstar.com/articles/270494/2008s-etf-winners 2. Stocks vs bonds in bear markets chart data – Aswath Damodaran (Note: Link shows not secure.) http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html