When seeking portfolio balance and diversification, many investors choose bonds and other fixed-income securities. But just like all investments, bonds carry risk. Learn about bonds and bond risk, and when you should consider fixed-income investing.
Do these words look familiar to you?
Investments in fixed-income products are subject to liquidity (or market) risk, interest rate risk (bonds ordinarily decline in price when interest rates rise and rise in price when interest rates fall), financial (or credit) risk, inflation (or purchasing power) risk, and special tax liabilities. May be worth less than the original cost upon redemption.
This warning appears in every TD Ameritrade article on bonds or other fixed-income securities. Sometimes in a paragraph, sometimes in the disclaimers at the bottom. And reading it, you might think, “Why should I invest in such things given all these risks?”
As with any investment, bonds offer both risk and potential returns. And when used as part of a diversified portfolio, bonds and other fixed-income investments can help enhance the overall risk-adjusted return profile. Here’s a look at bonds, bond risks, and why investors may choose to invest in bonds.
Before getting to bond risks, let’s talk about potential benefits. Because despite those warning words above, people invest in bonds for a variety of very good reasons.
Bonds have unfairly gotten an “Eat your veggies” kind of reputation. It’s a lot more tasty, some investors might think, to sink money into that exciting new technology or biotech stock than to follow market veterans’ advice about spreading risk and buying Treasury bonds with a 1.9% yield.
Bonds might look like a plate of broccoli, but remember that broccoli has lots of vitamins and fiber that can keep you healthy. Think of bonds as being a little like broccoli for your portfolio, if things go well (remember, no investment is guaranteed to give your portfolio big muscles).
Let’s look at some potential advantages of having fixed income as part of your investment menu. First, bonds are often less volatile than stocks. Also, bonds sometimes outperform stocks when a bear market hits, which may provide protection for investors who put together more balanced portfolios.
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Plus, although some companies pay dividends on their stock, it's often the first to get chopped when hard times come. That’s one reason why, if you normally seek income through dividend stocks, you might want to consider also looking into corporate bonds. These investments come with risks of their own, and even Treasury bonds aren’t risk free (more on that below). But in general, corporate bonds are considered a bit less risky than company shares, which can be affected by dividend cuts as well as stock market turbulence.
“In times of a default, bonds pay out first, while common equity is last to be paid,” said Perry Guarracino, director of fixed income trading at TD Ameritrade.
You don’t necessarily need to devote a huge portion of your portfolio to bonds when you start out as an investor, but you might want to consider having at least a small amount of assets in bonds and accept a lower potential return in hopes of more stable growth over time. All this is really a fancy way of restating that old warning about not putting all your eggs—or in this case, broccoli—in one basket.
Maybe the idea of a bond investment conjures up thoughts of older investors, and certainly bonds can help retirees generate income when they no longer have a paycheck. But bonds also play a role in preserving money by reducing risk through diversification, although they can have a downside, including interest rate risk.
“It’s important to diversify early on,” said Roza Shamailov, senior manager, fixed income at TD Ameritrade. “One way to diversify is by investing in stocks and bonds—two asset classes that tend to respond differently to market events. This can help reduce volatility and help manage the risk of losses during bear markets.”
Government bonds tend to be viewed as less risky, but corporate bonds can offer a different approach into the same companies where you may already own stock.
“If you’re an equity investor, a corporate bond gives you an opportunity to own a different security or instrument relative to a company you may already be aware of,” Shamailov explained. So if you own a certain stock, that company may also offer bonds. Investors may have affinity for that name. And depending on where you are in the market cycle, a corporate bond should yield more than a stock dividend.
“The great thing about a corporate bond is that it can offer a steady income stream and can be a stable investment, provided there’s no credit event,” Shamailov continued. “Investors can buy the bond, collect the interest payments, and receive the face amount back when the bond matures.”
What’s a credit event, you ask? It’s one of the risks inherent in any bond investment. Here’s a rundown.
All that may sound pretty good, but if someone tries to tell you bonds are a “totally risk-free” investment, run the other way. Fixed income can be a great way to manage risk across different asset classes, but like anything—whether it’s a financial investment or that pull-up bar at the gym—it’s important to understand the risks before you jump in.
Inflation risk. Government bonds tend to be less risky than corporate bonds, but they usually have a lower interest rate. Your risk there isn’t necessarily default—unless something really, really bad happens to the U.S. economy—but you do take on the risk of having a lower potential return over time. In a sense, you’re trading potential growth for potential safety (though neither is guaranteed). If you devote too much of your portfolio to low-yield bonds, the risk is that inflation might outpace your returns.
Default risk. Although corporate bonds generally pay higher rates than government ones, corporate bonds pay different coupon rates that range from quite low to quite high. This is because of something known as default risk, which happens when an issuer isn’t able to pay back the principal—or make any remaining interest payments—on the bonds it's issued.
There’s generally a lower risk of default for municipal bonds—issued by states, counties, school districts, and other municipalities to help pay for capital projects—but investors should understand and be comfortable with the issuer of the bond. Arguably, the biggest corporate bond risk and municipal bond risk is default, even if it doesn’t happen all that often.
Credit risk. Although defaults are rare, the probability that a company, municipality, or even nation might default on a bond can fluctuate. Such probabilities are tracked by ratings agencies such as Moody’s, Fitch, and Standard & Poor’s. These agencies rate the quality of bonds and assign a rating or risk assessment—typically a letter system from high-quality AAA down to C or D, signifying bonds already in default—to indicate the creditworthiness of each entity they track. As the likelihood of a default ebbs and flows, an agency might issue an “upgrade” or “downgrade” depending on the circumstances. A credit downgrade can lead to a fall in the price of bonds issued by a company.
Interest rate risk. There’s also a chance interest rates could fall in general, which tends to happen when the economy slows down. This is known as interest rate risk, and every bond has it at least to some degree. When interest rates go up, bond prices fall, and vice versa. Interest rate risk arises from the potential that changes in interest rates, both in the U.S. and abroad, may reduce the market value of a bond you hold. Interest rate risk diminishes the closer it gets to the bond’s maturity.
This might not be an issue for investors who plan to hold the bonds to maturity—if you hold a bond to maturity, you’ll have received all of the interest at the coupon rate, plus you’ll get your principal back—but it can still be a good idea to plan for the unexpected, or be more conservative if there’s a possibility you might need to sell before maturity.
“Regardless of the direction of interest rates, one thing never changes—your income,” Guarracino said. “Buyers of bonds should consider themselves investors rather than traders.”
Liquidity risk. There’s one final risk to consider. If you decide to sell a bond before maturity, your broker will need to solicit bids from dealers. Typically, the market—for big-name issuers, anyway—is deep and liquid, but during times of market stress, or before and after a credit downgrade, there’s a risk that you might have a hard time finding a buyer for your bond. That’s liquidity risk.
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You can’t necessarily account for every possible twist and turn of the market, and there’s always a chance of losing money when investing, but there are ways to try and manage the risk that comes with bonds.
Build a ladder. “If you want to prepare for future changes in interest rate rises, one way is to build a bond ladder,” Guarracino said. “You can build it any way you want, so that you have bonds maturing every six months, every year, or every two years.” You always have the ability, as each bond matures, to fill up the back of the ladder. This can be especially effective in a rising rate environment.
For instance, if a ladder consists of bonds maturing in one, two, three, four, and five years, when the one-year bond matures in a rising interest rate environment, you could buy a five-year bond at a higher rate and keep the ladder going.
There’s also a chance rates could fall, which tends to happen when the economy slows down. However, building a ladder helps hedge against that risk as well.
“You can always adjust,” Guarracino said. “That’s the beauty of building a ladder. If rates fall, then you might consider reinvesting on the shorter end. You can always adjust your ladder as things mature.”
Do your research. Before buying a municipal or corporate bond, check its ratings and see what analysts have to say about the company. Read the prospectus. Look back at past performance (although past performance is no guarantee of future results). In other words, take the time to educate yourself before jumping in, just as you would with a stock.
Doing research and building ladders—this might sound distinctly like “Eat your broccoli.” However, investing comes with homework if you want to help protect and build your portfolio. That goes for fixed income as well as whatever hot biotech stock comes along.
Although bond risks always exist to at least some degree, investment-grade bonds can be less risky than stocks and can potentially add a measure of balance and diversification to a portfolio. A bond fund or exchange-traded fund (ETF) can help spread the risk across a number of issuers. So if one issuer defaults, most of the fund or ETF investment isn’t typically affected.
Need help or more information? Consider reaching out to a TD Ameritrade Fixed Income Specialist at 877-883-2835, or watch the video below.
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