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Risks Involved in Buying Bonds

There’s a poker saying that if you can’t spot the sucker at the table, you must be the sucker. The investing corollary:

If you can’t spot the risk in an investment, you don’t understand the investment.

Bonds are generally assumed to be a low-risk investment. And in many (though not all) cases, that’s true. But they’re never risk-free.

For example, there are three ways you can lose money by investing in bonds. (For the moment, we’ll ignore risks such as reinvestment risk that, while they can cause your return to be lower than expected, do not cause a loss of capital.)

Default Risk (a.k.a. Credit Risk)

The first and most obvious risk involved in a bond transaction is default risk: the risk that the borrower will go belly-up and be unable to make the promised payments.

  • Junk bonds have high default risk.
  • Corporate bonds have moderate default risk.
  • Municipal bonds (usually) have low default risk.
  • Treasury bonds are assumed to be free of default risk.

In every case except for Treasury bonds, buying a bond fund or ETF rather than individual bonds can help you reduce default risk via diversification.

Inflation Risk

Unexpected inflation is a significant risk when your interest payments are held constant.

For example, had you bought a 10-year Treasury bond at the end of 1971, you would have received a nominal return of 5.9% over the life of the bond. Unfortunately for you, inflation over your 10-year holding period was an annualized 8.7%. Ouch.

The longer the term of the bond, the greater the threat of inflation risk. So one of the best ways to minimize inflation risk is to own short-term bonds.

A second way to protect yourself from inflation risk is to buy Treasury Inflation-Protected Securities (TIPS). These bonds promise a specific after-inflation return rather than a specific nominal return.

Interest Rate Risk

When interest rates go up, bond prices go down (and vice versa).

For example, imagine that you buy a 10-year Treasury bond paying 3% interest. Now, imagine that one year later, the interest rate on new Treasury bonds has gone up to 4%. If you wanted to sell your 3% bond, who would buy it? Nobody.

…unless they were able to buy it at a discount–specifically, a discount large enough for them to earn an effective 4% rate.

Two notes about interest rate risk:

  1. The longer the maturity of the bond, the more its market price will fluctuate as a function of current interest rates. End result: If you have a short time frame, a 30-year bond (even a US Treasury bond) is not a safe investment.
  2. While TIPS are not subject to inflation risk, they are subject to interest rate risk. This means that you can lose money by purchasing TIPS if you have to sell them prior to maturity and market interest rates are higher than they were at the time of your purchase.

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Comments

  1. Mike,

    It’s great to see the risks of bonds explicitly stated. I think people tend to gloss over the inflation and interest rate risks when thinking about bonds. It seems to me that today may be a very risky time for bonds as we have historically low interest rates and lots of government spending that could lead to inflation…

    -Rick Francis

  2. All this being the case, under what circumstances would you want to go long-term with bonds?

  3. @Larry: For me personally? Never! Any bond longer than 10 years has too much risk for the above mentioned reasons. William Bernstein has some stats in his books.

    Tax and political risks are other risks not mentioned. These can be an issue for investments, especially in the environment we live today.

    The one lesson that should be learned for any investment. There is no such thing as “100% risk free” investments. ALL (I repeat ALL) investments have risk and it’s wise to determine those risks. That CD that’s FDIC insured? It has inflation and interest rate risks.

  4. Hi Larry. That’s a great question. I plan to tackle it in more depth in a blog post soon. But for right now, my answer is that it depends entirely upon your goal with the investment.

    If the purpose is simply to serve as a low-volatility asset class in your portfolio, I’d stick with short-term bond funds every time.

    If, however, the goal is to fund a specific cost at a specific point in the (distant) future, a long-term TIPS might be a good fit in that it would make it easy to see how much you need to invest now to pay for that expense later.

  5. IJ: “That CD that’s FDIC insured? It has inflation and interest rate risks.”

    Exactly! And one could argue that those risks are as least as great as the volatility risks inherent in equities. This is probably the main reason I see red when That Blond Woman on CNBC keeps advising people to hold on to a lot of FDIC-insured cash to keep themselves “safe and sound.”

  6. Larry: You mean Suze Orman? The one who has very little (less than 10%) skin in the stock market? She caters to the Joe six pack, and not to the intelligent investor.

  7. That’s the one! (Though she’s usually addressing Jane six-pack rather than Joe.)

  8. Great article as per usual. 🙂 Just a note (which I know you know!): Inflation/rate risks do increase with duration, but of course that’s usually reflected in a higher yield for the long-term bond.

    As usual (but not always): higher risks, higher reward.

  9. Larry: Even better yet did you know she was a spokesperson for the FDIC?

    http://www.youtube.com/watch?v=eX_nLEe0SPE

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