With the recent volatility in the stock market, it is no surprise that some have been looking for investments that offer safer returns. Bonds appear to be one of these ‘safe’ investments that offer nice returns with not much risk. Considering the fact that over the past 10 years corporate bonds and Treasuries have gained when blue-chips lost, investing in bonds seems like a good bet. And, of course, conventional investing wisdom tells us that bonds are “safe”. But is investing in bonds really safe?
What are Bonds?
As you probably know, bonds are basically IOUs. You lend money to corporations or to government entities (through Treasuries, domestic municipal bonds and foreign bonds). You receive regular income from interest payments, and when the bond matures, you receive the principal back. There are also bond funds that invest in a variety of different types of bonds, and provide you with relatively low cost returns. These bond funds are becoming popular due to the promise of income from an investment that is more stable than stocks. But just because there is less volatility with bonds, it doesn’t make them completely safe.
Risk of Loss With Bonds
Just like any investment, bonds come with the risk of loss. The corporation or government might default on the bond, meaning that you don’t get your principal back. Your only return comes from the interest that you have been paid thus far. Bonds that have higher returns generally come with higher risk. Bonds from emerging market countries, for example, come with greater risk of default than U.S. Treasuries.
Bonds are rated according to their perceived risk, and highly rated corporate bonds are returning rather low rates right now because so many investors are demanding them to shore up their portfolios. Companies and countries with lower ratings have higher yields, but you are trading relative safety for these returns.
Another risk you run into when investing in bonds is interest-rate risk, which is the risk that you could be earning higher returns elsewhere. In most cases, you lock in a rate of return with bonds. You are tying up your money for a set period of time. While there is a secondary market for bonds, you are still likely to take some sort of a loss when you sell a bond, depending on the fees involved and what you sell the bond for. Bonds can be great if you think interest rates will fall, since you lock in better returns. However, if interest rates rise, you have committed money that can’t be used elsewhere for higher returns.
The safest bonds, in spite of warnings of a drop to the U.S. debt rating, remain U.S. Treasury Bonds. The U.S. has what is considered the most stable taxpayer base in the world, and that supports the idea of safety with U.S. Treasuries. However, as you might expect, Treasuries come with rather low yields — especially right now with so many people clammering for them. Indeed, 10-year bonds are barely keeping pace with inflation. (TIPS and I-bonds can help protect you from inflation.) But, even though the risk of default is generally expected to be small, the risk that the U.S. government will bail on its obligations is always there.
Bottom line: While bonds can add some stability to your portfolio, and bond funds can provide income streams and bond diversification, it is important to realize that there is no guarantee of safety. There is always the risk of loss, and you should carefully consider your goals and your asset allocation to ensure that your portfolio isn’t too heavily weighted with bonds, restricting the growth you require to meet your future needs. Proper asset allocation remains the key to hedge your risk across multiple types of securities.