The Risks of Bonds
If you’re a conservative investor nearing retirement, a large chunk of your portfolio probably consists of bonds. You may believe your money is safe, and that you’re guaranteed to make money from your investment. While bonds are generally safer than stocks, they are by no means risk-free. In fact, bond investments are a lot riskier than you may have been led to believe. With the combination of default risk, interest rate risk, inflation, and low rate of return, your investment, and your retirement, could be in jeopardy.
The bond market is changing, here’s what you need to know.
What is a bond?
A bond is an agreement between you as the lender and another party as the borrower. That borrower could be a government, a corporation, or even a municipality. To simplify bonds, let’s think about them in terms of an investor loaning money to a company. That company will give the investor regular interest payments for a period of time, typically 10 or 20 years. At the end of that time period, the investor receives their original money back.
Things get a bit more complicated when bonds are openly traded on the public market. When you go to buy a market bond, that bond is priced according to what the market will bear. These bond prices will rise and fall as interest rates rise and fall.
Interest Rate Risk of Bonds
Interest rates and bond prices are inversely related. When interest rates decrease, bond prices increase. For the past 20 years, interest rates have been falling, causing bond prices to go up. However, experts argue that we may be at the bottom of this trend. As the federal reserve tries to combat inflation by raising interest rates, bond prices will go down. This will decrease the value of the bonds you hold.
There’s a rule in the financial services industry called the 10-1-10 Rule. A ten-year duration bond with a 1% interest rate movement causes a 10% price movement in the opposite direction. For example, if you bought a 10-Year Disney bond for $1000, and interest rates move up 1%, tomorrow the value of your bond will now only be worth $900, which is a 10% loss.
This may not seem like a huge problem if you only have a few bonds of low value. But, if you’re retiring soon and have a million-dollar portfolio full of bonds, you could be in serious trouble. Rising interest rates, paired with the low rate of return bonds tend to have, could mean you’re taking a lot of risk for very little reward.
If you consider yourself a conservative investor, be wary. The bond market is changing second by second.
Default Risk of Bonds
Many conservative investors believe that their individual bond investments are completely safe, but that isn’t the case. There is always a chance that the borrower will not be able to repay the loan. This is called default risk.
Take this story for example. In 2011 General Motors needed a bailout. The government stepped in and essentially forced the bondholders to take zero for the money they had in that individual bond. The bondholders got nothing for their investment and lost their capital.
Some bonds have greater default risk than others. Many consider government bonds to be the highest rated, with nearly zero risk of being defaulted on. However, corporate bonds are a bit riskier.
One way to avoid default risk is to invest in a bond fund. This way, your money is spread out, not in one company. However, avoiding this risk comes at a cost – administrative costs specifically. Many bond funds have costs and fees built into them that clients may not be fully aware of.
Alternatives to Bonds
So, how can you avoid all these risks while still getting a good return on investment? There are many alternatives available to individual bonds and bond funds, including floating rate funds, REITS (Real Estate Investment Trusts), ETFs (exchange-traded funds), and life insurance policies. The qualified financial advisors at DuPont Wealth Solutions are able to discuss your options with you and help you avoid the risks associated with bonds. Give us a call at 614-408-0004 for a complimentary investment analysis.