Bond investments can serve as a great tool to generate income and are widely treated to be a safe investment, especially when compared with stocks. On the other hand, investors need to be aware of some possible pitfalls and risks to holding corporate and/or government bonds.
In this article, we will talk about the major risks that are associated with bond investments.
Interest Rate Risks
Interest rates and bond prices have an inverse correlation. That means if interest rates fall, the price of bonds trading in the marketplace rises in general. Conversely, a rise in interest rates usually make bond prices fall down.
This happens because when interest rates are on the slide, investors try to capture or lock in the highest rates they can for as long as they can. in order to do this, they scoop up existing bonds that pay a higher interest rate than the current market rate.
They also increase in demand translates into an increase in bond price.
On the other hand, if the current interest rate were on the rise, investors would naturally ditch bonds that pay lower interest rates.
Reinvestment Risks and Callable Bonds
Another danger that bond investors face is reinvestment risk, which refers to the risk of having to reinvest proceeds at a lower rate than the funds’ previous earnings. One of the main ways this risk presents itself is when interest rates fall over time and callable bonds are exercised by the issuers.
The callable feature enables the issuer to redeem the bond ahead of the security’s maturity. As a consequence, the bondholder receives the principal payment, and that payment is usually at a slight premium to the par value.
On the other hand, the downside to a bond call is that the investor is then left with a stack of cash that he or she may not be able to reinvest at a comparable rate. The reinvestment risk can have a major adverse impact on an individual’s investment returns over a period of time.
When you buy a bond, you essentially commit to receiving the rate of return, either fixed or variable, for the period of the bond bat least as long as it is being held.
However, what will happen if the cost of living and inflation spike up drastically and at a faster rate than income investment? When that happens, investors will see their purchasing power erode. Worse, they may actually achieve a negative rate of return.
Credit/Default Risks of Bonds
When you buy a bond, you are basically buying a certificate of debt. In simple words, that bond is borrowed money that the company must repay over time with interest. Many investors don’t realize that corporate bonds are not guaranteed by the full faith and credit of the US government. They rather depend on the corporations ability to repay the borrowed money.