Is Investing In Bonds Risky?
Is investing in Bonds risky? Yes! Many conservative investors see bonds as “risk-free” and a safer investment than stocks. However, as you will soon discover, this is not always the case!
What Is A Bond?
First, it is important to understand what a bond is. Bonds are considered fixed-income investments. When a person invests in bonds, they are “lending” money out to a corporation or a government entity. In return, the investor receives a steady interest payment on this loan over time. If the bond is held until maturity, the investor is guaranteed their “original” amount of principal back.
Interest payments are made with a coupon on the bond, and the riskier the bond normally, the higher the bond’s yield. In other words, the greater the risk…the greater the yield! A good example of risky bonds would be junk bonds. These bonds are issued by companies with poor credit. With junk bonds, you may, or may not, get your interest and principal back.
What Are Some Types Of Bonds?
There is a broad range of bonds including Treasury Securities, municipal bonds, zero coupon bonds, and junk bonds. With Treasury Securities you are lending money to the U.S. government. U.S. Treasury Securities consist of bonds, notes and bills. These treasuries are considered safe as they have the financial backing of the federal government.
Municipal bonds are tax exempt and ideal for individuals in a high tax bracket. Zero coupon bonds are issued at a discount from face value and do not pay interest. Junk bonds are a high risk security. Companies that issue junk bonds usually have financial problems and are looking to raise capital quickly.
How Are Bonds Risky?
However, there are risks inherent in bonds! A major risk is a very “small” or even a negative return. Historically, bonds have not been able to keep up with inflation! For example, if a bond was paying 2% interest, and the average inflation rate is 3%, and after taxes are deducted, the individual would have a negative return!
Another risk bonds carry is a credit risk. This is the risk of “default” when the company is unable to pay the investor interest. The company may even have to repurchase the bond.
There is also the possibility of interest-rate risk. Bonds are sensitive to changes in interest rates and, when interest rates rise, bond prices fall. Short-term bonds are less sensitive to interest rate changes. So, if one were to even consider bonds it would be smart to purchase a bond with a short-term maturity (less than 3 years)! Bonds can be riskier long-term.
Most people think of bonds as a “safe” investment with low risk and a guaranteed return. However, studies have shown that bonds can be almost as volatile as stocks. Moreover, there is the additional risk that the bond market could decline.
There are also bond mutual funds. However, remember that the bond mutual fund manager can charge you hefty fees while performing the research and homework for you.
Many investors, as they get older, purchase bonds for their safety feature and retirement. Suggestions by the experts are that as individuals age they should cut their stock exposure down. They advise older people to allocate more of their monies to bonds.
In conclusion, conservative investors tend to invest in bonds for the safety feature and the steady interest payments. However, contrary to popular belief, bonds are not always safe and risk-free! Bonds can carry credit risks, interest rate risks, inflation risks, and market risks. And, another “big” risk is that bonds have not outperformed the returns on stocks long-term!
I, personally, am not a huge bond fan and strongly suggest stocks. Especially for the younger person that has a long-term horizon in which to invest. I do not recommend bonds for any investor seeking high returns. History has clearly shown that bonds “under-perform” stocks. Over the long-term stocks outperform safer investments. Especially, when it comes to inflation and taxes!
