Fixed-income debt securities come in many shapes and forms. You’ve learned about corporate, US government, and municipal securities in this unit. Now we’ll focus on the benefits, risks, and typical investors associated with these investments.
The primary benefit of bonds is interest income. Most bonds pay interest semiannually, and those interest payments are legal obligations of the issuer. Unlike stock dividends, interest payments don’t require approval by the Board of Directors (BOD). If an issuer misses an interest or principal payment, bondholders can take legal action, and the issuer may be forced into bankruptcy. Because of this legal obligation, bond income is generally more predictable than stock dividends.
Capital appreciation can occur, especially if interest rates fall. However, interest rate movements are difficult to predict, and bonds mature at par. If you hold a bond to maturity, you’ll receive the face (par) value at maturity. For that reason, most bond investors don’t focus on capital appreciation unless their bond is convertible.
While it isn’t always true, bond prices are often less volatile than stock prices. Since bond interest is a legal obligation and isn’t tied directly to a company’s profitability, price swings are typically smaller. There are important exceptions:
Some benefits depend on the type of issuer:
As a reminder, systematic risks affect a large portion of the overall market. For bonds, the two key systematic risks are interest rate risk and inflation (purchasing power) risk.
Earlier in this chapter, you learned about price volatility and duration, which both relate to interest rate risk. Bonds with long maturities and low coupons tend to move the most in price when market conditions change. In practice, bond prices are most commonly influenced by changes in interest rates.
Interest rate risk (sometimes called market risk for bonds) is the risk that interest rates rise, causing bond market prices to fall. Prices fall because older bonds with lower coupons must become cheaper to compete with newly issued bonds offering higher interest rates. Interest rate risk applies to all fixed-income investments, including preferred stock.
We discussed inflation (purchasing power) risk in the preferred stock suitability chapter. This risk occurs when inflation reduces the real value of an investment’s cash flows. Bonds are especially exposed because their coupons are fixed: investors receive a fixed dollar amount of interest over the life of the bond. If prices rise across the economy (for example, food, cars, and housing), that fixed interest payment buys less.
When inflation rises, the Federal Reserve (the central bank of the US) often raises interest rates to reduce borrowing and slow demand, which can help stabilize prices. This is why purchasing power risk and interest rate risk are closely connected: when interest rates rise, bond market prices fall.
Just like interest rate risk, purchasing power risk increases as maturity increases. One common way to reduce inflation risk is to use short-term bonds. When a short-term bond matures, you can reinvest the proceeds at current (potentially higher) interest rates instead of being locked into a lower rate for a long time.
Non-systematic risks affect specific securities rather than the entire market. Bonds have several important non-systematic risks.
Default risk (also called credit risk or repayment risk) is the risk that an issuer can’t make required interest and/or principal payments. The most common cause is bankruptcy.
Bankruptcy isn’t common, but it does happen. Corporations - and, more rarely, governments - can default on their debts. For example, the city of Detroit declared bankruptcy and defaulted on its bonds in 2013. It was (and still is) the largest default by a municipal (local government) issuer in US history. If you held a Detroit bond at the time, you likely lost a substantial amount of money.
Rating agencies help investors assess default risk. Standard & Poors (S&P), Moody’s, and Fitch are the three rating agencies to know for the exam. Their rating symbols differ slightly, but all focus on default risk. Here’s how their ratings appear:
It’s important to distinguish between investment grade and speculative bonds:
Liquidity risk (also called marketability risk) is the risk that a security can’t be sold quickly at a fair price. A bond with high liquidity risk may be difficult to sell at all, or it may require a deep discount. In general, the less desirable a bond is to other investors, the higher its liquidity risk. For example, if a company is close to bankruptcy, you may only be able to sell its bond at a steep discount (or not at all).
Some investments tend to have higher liquidity risk than others. Municipal bonds are known for liquidity risk, largely because of their tax status. Since residents receive tax-free income, trading often stays within a smaller group of local buyers. The smaller the municipality, the fewer potential buyers. In contrast, US Government securities trade globally and are among the most liquid investments in the world.
Legislative risk is the risk that a new law or regulation (usually domestic) harms an investment. For example, the tariffs imposed by the Trump administration starting in 2018 increased the cost of doing business with certain foreign companies. Investors holding securities tied to international trade experienced legislative risk when markets responded negatively to the trade war.
Political risk is the risk that government instability or a sudden change in government harms an investment. For example, suppose you own a Ukrainian bond. If an unexpected military coup replaces the government, the bond could default. Unless the new government chooses to honor the prior government’s debts, you could lose a significant amount of money.
Political instability can happen anywhere, but it’s most often discussed as a foreign risk. The United States has political disagreements, but it has a relatively stable political structure.
Reinvestment risk is the risk that you’ll have to reinvest cash flows at lower rates when interest rates fall. You’ll see this risk most often with bonds that have high coupons, frequent interest payments, and callable features.
Although bond prices generally rise when interest rates fall, reinvestment risk focuses on what happens to the cash you receive and then put back to work. Long-term investors often keep their money invested continuously. When a bond pays interest, that cash can be reinvested into new bonds (or more of the same bond). If interest rates have fallen, that reinvestment typically earns a lower return.
Earlier in this chapter, you reviewed callable bonds. Call risk is a type of reinvestment risk that occurs when a callable bond is likely to be called (or is called). Bonds are most likely to be called when interest rates fall, because issuers can refinance by issuing new bonds at lower rates.
Call risk is often considered the worst form of reinvestment risk. Instead of reinvesting only the interest payments at lower rates, you must reinvest both the interest and the principal returned when the bond is called. Since the amount being reinvested is larger, the impact can be substantial.
The last risk relates to yield. Municipal bonds can provide tax-free income, but that benefit comes with a trade-off: lower yields. Issuers can often offer lower yields because investors don’t pay taxes on the interest. While this isn’t always a severe risk, an investor in a low tax bracket should generally avoid municipal bonds. Otherwise, they may face opportunity cost if other investments could provide a higher after-tax return.
Bonds vary widely in their risks and benefits. This section describes the typical bond investor in general terms.
Compared with stocks, bonds are often preferred by older, more conservative investors. Because interest payments are a legal obligation of the issuer, bonds typically involve less risk than common stock, which usually means lower expected returns. Investors who want predictable income often choose debt securities over equity (stock) securities.
Remember the Rule of 100? As a general guideline, the older an investor is, the more they allocate to fixed-income investments like bonds. Here’s the table from the suitability section of common stock:
| Age | Stock % | Bond % |
|---|---|---|
| 30 | 70% | 30% |
| 45 | 55% | 45% |
| 60 | 40% | 60% |
| 70 | 30% | 70% |
With bonds, the Rule of 100 is often stated this way: an investor’s age roughly matches the percentage of bonds in their portfolio. This is a general guideline, not a rule that always applies. Some older investors can afford to take more risk (for example, an 80-year-old billionaire may choose a higher stock allocation). Some younger investors are more risk-averse and prefer a larger bond allocation. Use the Rule of 100 as a starting point, and expect exceptions.
You’ll also see that not all bonds are “safe.” Some bonds carry significant risk. Junk bonds and other high-risk debt securities often offer higher yields, but investors can lose substantial amounts if a default occurs.
Interest income is the primary reason most investors buy bonds. If an investor isn’t seeking income, another asset class may be more appropriate. One exception is zero coupon bonds, which pay interest only at maturity. If an investor wants a predictable payout years in the future but doesn’t need income along the way, a long-term zero coupon bond may be suitable.
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