Bonds are traditionally viewed as the safest of investments. But that myth may be shattered in the months ahead, whether interest rates rise or fall. So, if you’re looking to hide out from the stock market by buying bonds or bond funds or ETFs, you should have a good idea of the risks involved.
A quick definition is in order. A bond is a debt, an IOU from a company or government promising to repay your money at a fixed date while paying you a fixed rate of interest along the way.
That’s a bit of an oversimplification because bonds have many quirks. But for this column, let’s just stick with the plain version of bonds that are issued by most companies and governments.
Typically, you pay $1,000 for a newly issued bond and plan to hold it until its maturity date, receiving interest along the way. What could go wrong? Plenty of things — and they might not be so obvious to novice bond-buyers.
The first risk is that the company might default, go out of business, or otherwise be unable to pay the interest or principal on its debt. You can guard against credit risk by purchasing only AAA-rated bonds. Bond rating companies assess credit risk and assign ratings.
These days those top-rated bonds don’t pay a very high rate of interest. So it is tempting to purchase a slightly riskier bond in order to earn more interest. The riskiest bonds are called junk bonds.
There is now about $2.7 trillion of BBB-rated corporate debt in the U.S. That rating is just one small step above junk. In fact, half of all investment grade debt in the U.S. is now rated BBB. Those bonds pay an enticingly higher yield than top-rated bonds. According to S&P Dow Jones Indices over the past 10 years, the S&P U.S. High Yield Corporate Bond Index has had an average annual return of 10.45%.
Most mutual funds and ETFs are prohibited from buying junk bonds, but some are loaded up with BBB bonds to capture the higher yields. What happens if a company has financial problems in a recession and the rating agencies downgrade its bonds? The funds could be forced to sell in a panic, pushing bond prices down.
A deep economic recession could cause huge selling in the bond market. And that means the price of bond funds, ETFs and individual bonds could decline sharply.
Interest rate risk
There’s another bond risk that applies to all bonds — even the highest rated bonds sold by the U.S. Treasury and by top-rated corporations. It’s called interest rate risk, and it’s based on a simple principle: Higher-yielding bonds of the same quality are more attractive than lower-yielding bonds. So if interest rates, in general, start rising, then older, lower-yielding bonds will be worth less in the bond marketplace. That’s true of all comparable quality and maturity bonds and bond ETFs, which hold fixed packages of bonds.
There isn’t much fear of interest rates moving higher at this point, as everyone waits for the Fed to cut. But if inflation were to return, rates would rise. That would make your good quality but lower-yielding bonds worth less.
The other risk in buying individual bonds is that you will pay too high a price when you buy and receive an unusually low a price when you sell. All bonds trade in an amorphous global bond market where it’s difficult to track the latest prices. To find the current price of a bond, go to FINRA.org and click on the “market data” center to search, so you won’t be victimized by an unscrupulous bond dealer.
You can avoid the pricing risk of individual bonds by purchasing a managed bond mutual fund, such as those offered by Fidelity and Vanguard. Before buying, read the description in the prospectus, telling you what quality of bonds the fund buys.
Just remember that even the best-managed bond funds have interest rate risk if rates rise. And also remember that bond ratings can slip when the economy trips. Bonds are not without their own set of risks. And that’s the Savage Truth.