Risks of Investing In Bonds

All investments offer a balance between risk and potential return. The risk is the chance that you will lose some or all the money you invest. The return is the money you stand to make on the investment.

The balance between risk and return varies by the type of investment, the entity that issues it, the state of the economy and the cycle of the securities markets. As a general rule, to earn the higher returns, you have to take greater risk. Conversely, the least risky investments also have the lowest returns.

The bond market is no exception to this rule. Bonds in general are considered less risky than stocks for several reasons:

• Bonds carry the promise of their issuer to return the face value of the security to the holder at maturity; stocks have no such promise from their issuer.
• Most bonds pay investors a fixed rate of interest income that is also backed by a promise from the issuer. Stocks sometimes pay dividends, but their issuer has no obligation to make these payments to shareholders.
• Historically the bond market has been less vulnerable to price swings or volatility than the stock market.

The average returns from bond investments have also been historically lower, if more stable, than average stock market returns.

A specific bond’s risk level is reflected in its yield, another name for return on a bond investment. “Current” yield is a function of the bond’s:

• Coupon rate: the annual interest rate the issuer promises to pay the investor, stated as a percentage of the bond’s face value or “par,” which is the amount the investor can expect to have returned on the bond’s maturity date.
• Current price, which may be a premium (more than) or discount (less than) in relation to the bond’s face or par value.

Yield-to-maturity reflects the relationship between the total coupon interest payments remaining between now and maturity, and the difference between today’s market value (price) and par value. Yield-to-call is the same calculation based on the total coupon interest payments remaining between now and the first call date (rather than the maturity date) as well as the difference between today’s market value (price) and the call price.

The higher the risk in a given bond, the higher its yield needs to be to compensate the investor for taking the risk. When the market perceives the yield on a bond to be too low, its price will fall to bring the yield in line with market expectations or prevailing interest rates.

Bonds issued by the U.S. Treasury are backed by the full faith and credit of the U.S. government and therefore considered to have no credit risk. The market for U.S. Treasury securities is also the most liquid in the world, meaning there are always investors willing to buy. U.S. Treasury yields will almost always be lower than other bonds with comparable maturities because they have the fewest risks.

Relative yields—which may be discussed in terms of “spread” or difference in yield between a given bond and a “riskless” U.S. Treasury security with comparable maturity—vary with the type of bond, maturity date, the issuer and the economic cycle.

Callable bonds are riskier than non-callable bonds, for example, and therefore offer a higher yield, particularly if the call date is soon and interest rates have declined since the bond was issued, making it more likely to be called.

Short-term bonds with maturities of three years or less will usually have lower yields than long-term bonds with maturities of 10 years or more, which are more susceptible to interest rate risk. All bonds have more risk when interest rates are rising, but those with the lowest coupons stand to lose the most value.

Duration risk is the modified duration of a bond is a measure of its price sensitivity to interest rates movements, based on the average time to maturity of its interest and principal cash flows. Duration enables investor to more easily compare bonds with different maturities and coupon rates by creating a simple rule: with every percentage change in interest rates, the bond’s value will decline by its modified duration, stated as a percentage. For example, an investment with a modified duration of 5 years will rise 5% in value for every 1% decline in interest rates and fall 5% in value for every 1% increase in interest rates.

Bond portfolio managers increase average duration when they expect rates to decline, to get the most benefit, and decrease average duration when they expect rates to rise, so minimize the negative impact. If rates move in a direction contrary to their expectations, they lose.

Interest rate risk When interest rates rise, bond prices fall; conversely, when rates decline, bond prices rise. The longer the time to a bond’s maturity, the greater its interest rate risk.

Reinvestment risk When interest rates are declining, investors have to reinvest their interest income and any return of principal, whether scheduled or unscheduled, at lower prevailing rates.

Inflation risk Inflation causes tomorrow’s dollar to be worth less than today’s; in other words, it reduces the purchasing power of a bond investor’s future interest payments and principal, collectively known as “cash flows.” Inflation also leads to higher interest rates, which in turn leads to lower bond prices. Inflation-indexed securities such as Treasury Inflation Protection Securities (TIPS) are structured to remove inflation risk.

Market risk The risk that the bond market as a whole would decline, bringing the value of individual securities down with it regardless of their fundamental characteristics.

Selection risk The risk that an investor chooses a security that underperforms the market for reasons that cannot be anticipated.

Timing risk The risk that an investment performs poorly after its purchase or better after its sale.

Risk that you paid too much for the transaction The risk that the costs and fees associated with an investment are excessive and detract too much from an investor’s return.

Legislative risk The risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.

Call risk Some corporate, municipal and agency bonds have a “call provision” entitling their issuers to redeem them at a specified price on a date prior to maturity. Declining interest rates may accelerate the redemption of a callable bond, causing an investor’s principal to be returned sooner than expected. In that scenario, investors have to reinvest the principal at the lower interest rates.

If the bond is called at or close to par value, as is usually the case, investors who paid a premium for their bond also risk a loss of principal. In reality, prices of callable bonds are unlikely to move much above the call price if lower interest rates make the bond likely to be called.

Liquidity risk The risk that investors may have difficulty finding a buyer when they want to sell and may be forced to sell at a significant discount to market value. Liquidity risk is greater for thinly traded securities such as lower-rated bonds, bonds that were part of a small issue, bonds that have recently had their credit rating downgraded or bonds sold by an infrequent issuer. Bonds are generally the most liquid during the period right after issuance when the typical bond has the highest trading volume.

Credit risk The risk that a borrower will be unable to make interest or principal payments when they are due and therefore default. This risk is minimal for mortgage-backed securities issued by government agencies or government-sponsored enterprises—also known as “agency” securities issued by Ginnie Mae, Fannie Mae or Freddie Mac—and most asset-backed securities, which tend to carry bond insurance that guarantees payments of interest and principal to investors.)

Default risk The possibility that a bond issuer will be unable to make interest or principal payments when they are due. If these payments are not made according to the agreements in the bond documentation, the issuer can default. This risk is minimal for mortgage-backed securities issued by government agencies or government-sponsored enterprises—also known as “agency” securities issued by Ginnie Mae, Fannie Mae or Freddie Mac—and most asset-backed securities, which tend to carry bond insurance that guarantees payments of interest and principal to investors.

Event risk The risk that a bond’s issuer undertakes a leveraged buyout, debt restructuring, merger or recapitalization that increases its debt load, causing its bonds’ values to fall, or interferes with its ability to make timely payments of interest and principal. Event risk can also occur due to natural or industrial accidents or regulatory change. (This risk applies more to corporate bonds than municipal bonds.)

Prepayment risk For mortgage-backed securities, the risk that declining interest rates or a strong housing market will cause mortgage holders to refinance or otherwise repay their loans sooner than expected and thereby create an early return of principal to holders of the loans.

Contraction risk For mortgage-related securities, the risk that declining interest rates will accelerate the assumed prepayment speeds of mortgage loans, returning principal to investors sooner than expected and compelling them to reinvest at the prevailing lower rates.

Extension risk For mortgage-related securities, the risk that rising interest rates will slow the assumed prepayment speeds of mortgage loans, delaying the return of principal to their investors and causing them to miss the opportunity to reinvest at higher yields.

Additional risks for callable and mortgage-backed securities

Negative convexity risk the convexity of a bond shows the rate of change of the dollar duration of a bond (modified duration expressed in dollars rather than years or percentage). Used in conjunction with modified duration, convexity improves the estimate of price sensitivity to large changes in interest rates. Option free bonds have positive convexity; bonds with embedded options, such as callable bonds and mortgage-backed securities, have negative convexity, meaning the graph of the relationship between their price and yield is convex rather than concave. Negative convexity creates extension risk when interest rates rise, and contraction risk when interest rates fall.

Early amortization risk Early amortization of asset-backed securities can be triggered by events including but not limited to insufficient payments by underlying borrowers and bankruptcy on the part of the sponsor or servicer. In early amortization, all principal and interest payments on the underlying assets are used to pay the investors, typically on a monthly basis, regardless of the expected schedule for return of principal. For more information, see An Investor’s Guide to Asset-Backed Securities.