Risks Facing By Today's Bond Investor
Just as with any investment, there are risks associated with buying even the most highly rated bonds. Your bond could be called or redeemed by the issue before the maturity date, or economic downturns and poor management on the part of the bond issuer could reduce or even destroy the value of your bond. Here are the details of the risks that you face as a bond investor:
If the bond issuer calls the bond then it redeems your investment and pays back your principal. Issuers call bonds if the interest rates drop and they have enough available cash to pay back outstanding debt. Calling the bond lets them eliminate the expense of making further fixed-interest payments for the duration of the bond term, and they can issue new bonds at a lower rate and save money. If your bond is called, you stop receiving interest payments from the investment so there is no sense to holding on to it.
Various economic conditions also impact the value of bonds. Interest rates and inflation are the two major economic factors that impact bond values directly.
A bond that was issued before an interest rate increase will lose value if it is sold before maturity since its price is likely to be lower than par value. When there is a fluctuation in interest rates, the bonds that you already hold often become a less attractive investment vehicle, and difficult to sell, since investors and traders will want bonds that pay higher interest rates than your does.
When interest rates fall so low that bonds are no longer attractive, many investors move into the equity markets to get a higher return. The corresponding lack of interest in bonds can further depress bond prices.
The other economic risk to bonds is, of course, rising inflation. If you hold a long-term bond to maturity there is a risk that rising inflation will erode the buying power of the interest payments and principal.
If the bond issuer encounters financial difficulties, which happens more often in corporate bonds than government bonds, the value of your bond could fall rapidly or even become worthless.
A constant but unforeseeable risk is when a rating service downgrades its rating of a company or municipal government during the life of a bond. This is known as creating a "fallen angel". Bond rating companies monitor bond issuer's financial conditions and management decisions in order to predict the health of that issuer's bonds. If downgrading does occur, investors usually demand a higher yield for existing bonds which means that the price of the bond falls in the secondary market.
The greatest risk a bond investor faces is default. Default means that the issuer has reneged on his promise to pay. There are two types of default. An issuer may default on interest, which means that you receive your principal back, but no interest is paid. An issuer can also default on repayment, which means that you may receive some of your interest but lose your principal.
Thoroughly researching a bond's performance, as well as the issuer's overall financial condition, as well as its past performance on bonds, can help you protect yourself from some risk. However, no one can predict the future, and past performance is no indicator of what will happen down the road. Be careful and never invest more that you can afford to lose.