The primary benefit associated with bonds is interest income. Most pay interest semi-annually, and the interest payments are legal obligations of the issuer. Unlike cash dividends from stock, no approval from the Board of Directors (BOD) is required to make an interest payment. This makes income from bonds generally more predictable and safe.
Capital appreciation (growth) could occur, especially if interest rates fall. However, interest rate fluctuations are not easily predictable, plus bonds always mature at par. If the investor holds the bond long enough, they’ll eventually receive the face (par) value back at maturity. Therefore, most bond investors don’t seek capital appreciation unless their bond is convertible (we’ll discuss this later).
While not always the case, bond market prices are less volatile than stock prices. With bond interest being a legal obligation of the issuer and not contingent on the company’s profitability, market price fluctuations are typically mild. Of course, there are exceptions. Wild market fluctuations will occur if interest rates fluctuate significantly or if the issuer is on the brink of bankruptcy.
Investing in bonds comes with several risks, some unique to bonds and some more general and applicable to all investments. We’ll first discuss systematic risks bond investors are exposed to. As a reminder, this category of risk applies to the broad market and cannot be eliminated through diversification.
We discussed price volatility earlier in this unit, which relates to interest rate risk. Debt securities with long maturities and low coupons tend to move the furthest in price when dynamics change in the market. The most influential factor in the bond market is interest rate fluctuations. Interest rate risk occurs specifically when interest rates rise, which forces market prices of bonds down. As a reminder, when market prices fall, secondary market bonds become more marketable as they compete with primary market bonds issued with higher interest rates.
While most bonds maintain a fixed interest rate, variable rate bonds exist (we’ll learn more later). These securities have coupons that adjust periodically (usually monthly or semi-annually) to interest rate changes, keeping their market values stable. Therefore, variable rate securities generally avoid interest rate risk.
Interest rate risk applies to all fixed income investments, including preferred stock.
We originally learned about the risks of inflation in the preferred stock chapter. Inflation (purchasing power) risk occurs when prices of goods and services in the economy rise more than expected. Inflation occurs naturally, but unexpected rises in inflation can devastate bonds and the economy. Remember our story about Zimbabwe in 2008? We even learned our own lessons on the impacts of inflation in the US from 2021-2023.
Fixed income securities like bonds are particularly susceptible to this risk due to their fixed coupons. Investors who purchase bonds receive a fixed amount of interest over the bond’s life. If prices of everything from milk to cars to real estate rise significantly, the fixed interest payments maintain much less purchasing power (buy less).
The US Government bond chapter will discuss how the Federal Reserve manages inflation. For now, you’ll only need to know they raise interest rates when inflation rises. Purchasing power and interest rate risk are very closely tied together for this reason. Like interest rate risk, the longer the bond’s maturity, the more purchasing power risk a bond has. To avoid the risks of inflation, investors should seek short-term bonds. By doing so, they can reinvest their maturity proceeds into bonds with higher interest rates instead of being stuck with a lower interest rate for a long time.
Risks exist no matter where interest rates go. Reinvestment risk occurs when interest rates fall.
Although bond prices rise when interest rates fall, reinvestment risk focuses on money reinvested back into the market. Long-term investors typically keep their money invested at all times. When an investment pays dividends or interest, that money could be used to purchase a new security (or buy more of the same security). Bond investors reinvest their money into bonds with lower yields when interest rates fall.
Bonds with the highest and most frequent interest payments have the most reinvestment risk. In the US Government bond chapter, you’ll learn about mortgage-backed securities, which make monthly payments to their investors. They have high levels of reinvestment risk due to the frequency of their payments. The more to reinvest, the more reinvestment risk. Conversely, zero coupon bonds essentially have no reinvestment risk. When a bond doesn’t pay ongoing interest, there’s nothing to reinvest!
Earlier in this unit, we learned about callable bonds. Call risk, which occurs when a callable bond is likely to be called (or actually called), is a type of reinvestment risk. Bonds are most likely called when interest rates fall, which allows issuers to reissue new bonds at lower interest rates (refinancing). Call risk is the worst form of reinvestment risk. Instead of just reinvesting interest received at lower rates of return, the investor must also reinvest the bond’s principal!
Now we’ll discuss non-systematic risks, which apply to a single investment or a small portion of the market. This category of risk can be essentially eliminated with diversification.
Default risk, sometimes referred to as credit or repayment risk, occurs when an issuer cannot make required interest and/or principal payments to investors. The typical reason for default risk is bankruptcy.
Bankruptcy isn’t very common, but it does happen. Corporations and even governments default on their debts (although government defaults are rare). 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 the history of the United States. If you held a Detroit bond then, you probably lost substantial money due to their bankruptcy.
Rating agencies help investors determine the default risk of specific bonds. Standard & Poors (S&P’s), Moody’s, and Fitch are the three rating agencies to know for the exam. While their ratings look slightly different, they all rate bonds based on their default risk. Here’s how their ratings appear:
You won’t need to know what every rating means, but you will need to know the difference between investment and speculative grade bonds. Investment grade bonds have little-to-no default risk and maintain ratings of BBB or higher. Speculative grade bonds, sometimes referred to as junk bonds, are subject to considerable default risk. The lower the rating, the more default risk. Speculative grade bonds have ratings of BB or lower.
Liquidity (marketability) risk occurs when a security cannot be sold or requires a deep discount to be sold. Certain investments come with higher levels of liquidity risk. For example, municipal bonds are notorious for their liquidity risk. We’ll learn about why in a future chapter.
Generally speaking, the less desirable a bond, the more liquidity risk it is subject to. If investors don’t like what a bond offers, it might be tough to sell it. For example, a bond from a company on the brink of bankruptcy may not be able to be sold without a drastic discount in price (or not at all).
Legislative risk occurs when a law or regulation negatively affects an investment. For example, the tariffs imposed by the Trump administration in 2018 increased the cost of doing business with foreign companies from certain countries. Investors experienced legislative risk when the stock market responded negatively to the trade war.
Political risk materializes when political instabilities negatively impact an investment. Examples include military coups, threats or acts of war, and mass riots. While political risk can happen anywhere, it primarily affects foreign securities from countries with unstable government structures. The PRS Group political risk index ranked the United States as the second safest for political risk within the listed countries in the North American and Central American region (Canada was first) and 19th overall. While the US political arena has been volatile for the last several years, it has not significantly impacted the stock market (example 1, example 2).
A wide variety of bonds are available to investors, which come with varying risks and benefits. The purpose of this section is to discuss the typical bond investor without being too specific.
Unlike stocks, bonds are usually sought out by older, more conservative investors. Because of the legally guaranteed interest payments, bonds experience lower levels of risk than stocks, leading to lower rates of return. Investors seeking safe, predictable income will likely choose debt securities over equity (stock) securities.
We’ll learn about the varying levels of risk unique types of bonds are subject to. While generally viewed as safe, plenty of risky bonds are out there. For example, junk bonds offer high yields. Of course, the investor could lose significant money if a default occurs.
As discussed above, interest income is the primary benefit of bonds. If an investor is not seeking income, they should invest in another asset class. The only exception is for zero coupon bonds, which pay interest only at maturity. If an investor seeks a predictable payout years later but doesn’t need income along the way, a long-term zero coupon bond could be suitable.
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