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What Are the Risks With Bonds?

Bond buying can be tricky, so approach with caution.

Written by Elaine King CFP® / August 8, 2022

Quick Bites

  • Bonds may be boring, but they can definitely be worthwhile, though you should approach with caution.
  • Take into account the stability of the bond issuer; these are long-term bets, and you want a trustworthy company or entity on the other end.
  • Interest rates and bond values are closely linked, so watch the market carefully.

Let's be honest. Bonds are boring. It's far more thrilling–if risky–to be a shareholder of stocks with unlimited potential than a lender of bonds with predictable income.

So, let’s imagine ABC company is looking to raise money and gives you two choices:

  1. The opportunity to buy 10 shares at $100 ($1,000 in total) to become a shareholder of ABC company and potentially multiply your money if the stock goes up (or lose it if they stock goes down).

  2. The opportunity to lend ABC company $1,000 in return for a 5% coupon a year plus your original $1,000 back in 10 years.

Which one would you choose?

Looking at it from the outside, the decision could seem easy, but understanding the risks of both may help you make a smarter decision.

As a shareholder buying ABC shares, the risk is kind of obvious; you can lose all your money but enjoy unlimited upside potential. On the other hand, as a bondholder of ABC, the risks are not so obvious. It's important to take into consideration these top three risks:

  • How stable is the bond issuer? What are the chances they will pay you back interest and principal at the end of the agreed term?

  • What's going on in the market? Interest rate increases lead to a decrease in bond values.

  • What is your purchasing power considering the inflation rate? It might seem like it's not worth it to buy a bond below inflation, but it's not that simple.

We'll explain more about each of those below.

The stability of the bond issuer

The worst issuer that I can remember in modern history has to be Argentina in 2001 when it defaulted on $1.3 billion of sovereign debt (government) leaving lots of bondholders without payment. The same thing happened in Greece in 2012. These types of anomalies have happened in unstable governments so pay attention to their balance sheets, especially the part that lists the ratio between assets and liabilities.

Tip

Note that these incidents are very rare with governments or companies with stable financials.

In general terms, the benefits of being a bondholder are twofold; you get the coupon amount (interest) annually and you get back your original loan amount.

The risk is measured by the financial stability of the issuer. Stable governments carry the least risk while companies with a lot of debt and few earnings and assets will carry the most risk. But you don’t need to have a PhD in bond evaluation to figure this out.

There are three main companies that do the work for you and look at these risks and grade bonds like a report card: S&P Global Ratings, Moody’s and Fitch. They assign bond credit ratings (grades) in four main categories A, B, C and D.

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I recommend staying in the A’s and Bs to ensure credit quality. For example, as of December 2021, there are only three companies with max grade AAA: Apple, Microsoft and Johnson & Johnson. On the other end are those with low B’s including Netflix, Tesla and Softbank, which have suffered financial instability lately in their earnings.

If you are a bond beginner, I suggest you start with U.S. government bonds and A-rated corporate bonds or better yet an ETF index fund of either government or corporate to maximize your diversification and minimize the risk.

Understanding the market

The first thing I learned when I was studying bonds at the university was about their inverse relationship to price and rates. So as interest rates go up, bond prices go down, and as interest rates go down, bond prices go up.

Let me explain with an example: Let’s say I sold you a bond back in 2012 when the U.S. Fed Funds Rate was at almost 0% and offered you a 1% coupon–you gladly took it because your alternative was to leave it in your savings account making 0%.

Fast forward to this year, the Fed Funds rate is almost at 2%. You will not accept the same deal because you can get a higher coupon because rates are higher. This increase in rates causes bond prices to go down because now no one wants a 1% coupon and as a bond issuer I will have to lower the price below $1,000 selling it at a discount. However, if I have an 8% coupon bond I can sell it over $1,000 because everyone will pay top dollars for it.

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As you can see, you must be careful when buying bonds in an increasing interest rate environment and ensure the coupon and price is fair compared to the market and its conditions. Always look at the par value, which always at 1,000 in addition to the coupon. For this, I recommend waiting for the Fed to increase the interest rates and looking at year end to buy individual bonds, because as stated before, the higher the interest rates, the more you can potentially get make.

Purchasing power and inflation

Most advisors recommend not leaving your cash in a savings account earning little or no interest due to loss of purchasing power, but why?

Historically, the consumer price index (CPI), which measures inflation, for the last 100 years has averaged 3.8%. As an example to what that effectively means, if you left a $20 bill in 2000 in your drawer, you could have bought four movie tickets. Today, that same $20 bill will only buy you one movie ticket. Your purchasing power has eroded. You should take that into consideration when buying bonds especially in the current environment where inflation is up more than 9%.

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So, all things remaining equal, you'd think that a bond buyer should not accept less than 9% of overall yield given that any amount less than 9% would be losing money, right? Not exactly. Yield is a combination of coupon and bond price and also bonds are often issued in 10-, 20- and 30-year terms so just because inflation is high today does not mean it will be 9% for the next 30 years.

The key word is expected because even if you buy a bond at a 5% coupon for 10 years, CPI is not expected to be 9% for 10 years. It's continued to be expected to average 3.8% in one or two years, so the 5% may be OK for your portfolio.

Please note that when buying bonds for the first time I suggest choosing a bond ETF index in several categories. Some examples of categories include government, corporate, high yield, international, mortgage backed, etc.

Lastly, the best way to lower the risk of bonds is to diversify your portfolio from just stocks because bonds tend to be inversely correlated to stock which historically means that as stocks go up, bonds go down and thus a good instrument to diversification and to mitigate the overall risk of the portfolio. Although it may not seem explicit, I do love bonds and I'm looking forward to entering a positive bond mark in the next couple of months.

About the Author

Elaine King

Elaine King CFP®

Elaine has served as the Family’s Financial Planner for over 1,200 families and 100 multigenerational family enterprises crafting actionable family financial plans.

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