If you are a neophyte investor, perhaps you have never invested in bonds before. Before you invest, you need to understand some of the risks associated with investing in bonds. Most people assume that all fixed-income investment instruments are completely risk free, but this is not the case. Even if you are an experienced investor, you may not be aware of all the potential shortcomings of bonds. For the purposes of this discussion, we are going to carefully examine the pitfalls and risks associated with bonds.
The most important risk factor you need to take into account is the interest rate. Even if you are new to investing, you are probably aware that every 6-8 weeks, the Federal Reserve (also known as the Fed) meets to evaluate the current condition of the economy. At each meeting, the Fed renders a decision regarding interest rates. If inflation has been increasing, the Fed will need to raise interest rates. If inflation is moderate or contained, the Fed will likely maintain the current interest rate level. However, if the economy is slowing down and there is very little inflation or maybe even deflation, then the Fed might decrease interest rates to stimulate the economy by making it easier for businesses to borrow money.
The reason why the current and future level of interest rates are important for bonds is because as interest rates go up, bond prices go down, and vice versa. If you are able to hold a bond until maturity, then interest rate movements do not really matter, because you will redeem the principal upon maturity. But often, investors have to sell their bonds well before the maturity date. If interest rates have moved up since you bought the bond, and you sell it prior to maturity, then the bond will be worth less that what you paid for it.
It is also important to understand the claim status of the bond you are buying. Claim status refers to your ability to recover your investment in the event the bond issuer goes bankrupt. If you are buying a government bond, such as a Treasury Bill, claim status is irrelevant, because the odds of the Federal Government going bankrupt are slim and none.
If you are buying a corporate bond, however, there is always a chance that the issuer could go out of business. In the event of liquidation, bondholders are given priority over stockholders. However, there are often several classes of bondholders. Senior note holders can often claim against certain kinds of physical collateral in the event of bankruptcy, such as equipment (computers, machines, etc. ). Regular bondholders claim after senior note holders. You should check your bond portfolio to determine what class your bonds are in. If you can not determine the class of your bonds, call your broker.
Next, you should always check the three most basic features of a bond; the coupon rate, the maturity date, and the call provisions. The coupon rate is the interest rate. Most bonds pay an interest rate semiannually or annually. The maturity date is the date that the bond will be redeemed by the issuer; simply put, the maturity date is when the company must pay back to you the principal you loaned to them. The call provisions refer to the rights of the issuer to buy back your bond prior to maturity. Some bonds are non-callable, while others are callable, meaning that the company can buy your bond back before maturity, usually at a premium.
Finally, you should also understand that if economic conditions become more favorable after you a buy a bond, and interest rates start to go down again, the issuer will likely issue a lot more bonds to take advantage of the low interest rates, and will use the proceeds to try to buy back any callable bonds it issued previously. So, when interest rates go down, there is an increasing likelihood that your bond will be redeemed prior to maturity, if in fact the bond is callable.
I hope this information will help you formulate a strategy for making wise decisions when investing in bonds. Even though bonds are normally classified as fixed-income securities, you now understand that there are risks associated with them. So, follow all of the procedures outlined in this article when evaluating the risk characteristics of bonds, and you will do fine.
Are Bonds Really Risk Free?
July 12, 2010
