Bonds have a reputation as a "safe" investment compared to stocks. In some respects, that's true. But they can also be risky, which is why investment advisors generally recommend that people in typical circumstances keep a balanced portfolio -- in other words, one that includes both stocks and bonds. If you have a retirement savings account, you probably do own stocks and bonds, contained within large institutionally managed funds, such as a retirement target-date fund.
When you buy a bond (or invest in a managed bond portfolio), you're essentially lending money to the bond issuer. The primary measure of risk in a bond investment is the credit quality of the issuer; that is, an analyst's assessment of the probability that the issuer will go bust and default on its obligation to repay you. Based on that assessment, the agency analyst will assign a bond rating (such as AAA, BBB and so on). The higher the rating, the more confidence investors have that the issuer possesses the long-term ability to fulfill its promises to them.
Risk Categories
Investors also need to be mindful of another big hazard: interest rate risk. You may have heard that there's an "inverse relationship" between the movement of market interest rates and the value of bonds trading in the markets. That means, for example, that, if interest rates rise, the value of bonds being traded in the bond markets go down. The opposite is also true. If interest rates fall, the value of bonds go up.
When the performance of bond funds is stated, it includes both the amount of interest collected and the changing value of the bonds in its portfolio.
Bond issuers, also referred to as borrowers, fall into several basic categories:
- U.S. Treasury,
- Financially strong corporations ("investment grade" corporate bonds),
- Financially shaky corporations (those with higher credit risk often called "junk bonds"),
- State and local public sector entities (typically referred to as "municipals" or "munis), and
- Bonds issued by the governments of other countries known as "sovereign" debt.
Bond Characteristics
Here are the hallmarks of each type of borrower you could lend your money to:
- Treasuries: These are the safest from a "credit quality" perspective, because they're backed by the "full faith and credit" of the U.S. government. Because of their popularity among cautious investors, however, treasury yields are lower than corporate bonds.
- Investment grade corporates: Although safer than "junk" bonds, there's a spectrum of credit risk within this category, from BBB- to AAA, using the Standard & Poor's rating scale. Keep in mind that a bond's rating can go up or down while it's still trading if the credit rating agencies revise their assessment of its credit quality.
- Junk bonds: Because of their greater risk, issuers are forced to pay higher interest rates to attract investors. The value of junk bond trading in open markets can be impacted -- to a greater degree than investment grade bonds -- by the ups and downs of the financial strength of the bonds' issuers.
- Munis: What makes munis stand out is that the interest they pay is exempt from federal income tax. And, if a muni is issued by your state (or an entity within your state), it's generally also not subject to state income tax.
- Sovereign debt: Fluctuations in global interest rates and the economic strength of the country that issued the debt affect the performance of this type of bond. For Americans, the debt performance also fluctuates according to currency exchange rates. For example, suppose you buy a bond issued by a country that uses the Euro. If the dollar drops in value relative to the Euro, the value of those bonds when translated to dollars will also go down, all else being equal. The opposite scenario is also possible, however.
Yield and Interest Rate Risk
Another fundamental facet of bond investing is that, the longer into the future a bond matures (when its issuer must repay the bond principal, the amount that was borrowed), the more vulnerable it is to interest rate risk.
Here's an example: Consider what happens to the market value of a bond currently yielding 4% when interest rates rise by 1%. An analysis shows that, if the bond has five years to maturity, the value would drop by about 4.6%. The same bond with 10 years to maturity would come with higher interest rate risk, and lose roughly 7.8% of value. With 20 years to maturity, it would lose about 12.6%.
The higher the yield on the bond, the lower the interest rate risk, So, in the example above, if the bond yield were 6% instead of 4%, the interest rate risk would drop and the bond's loss of market value would also be lower (around 4.1%, 7.1% and 10.6%, respectively).
Keep in mind that you'll only sustain a loss or gain in a falling interest rate scenario if you sell your bond (or the bond is sold by the investment manager of your fund). If instead you hold it until maturity, you'll collect the same amount of interest you would have otherwise received.
Strong Foundation
There's a lot more to know about bond investing, including the specific role bonds might play in your portfolio given your financial circumstances, risk tolerance and goals. We hope this introductory primer can lay the foundation for a strong understanding of the finer points of bond investing.