Bonds are financial securities to consider investing in when you want to build your investment portfolio. A bond is a security that bears interest, where the bond issuer pays the holder of the bond a set amount of money to repay the principal loan amount upon maturity. Compared to stocks, bonds can be great for investment as they are considered stable and safe. There are different types of bonds:
- Government bonds
- Municipal bonds
- Corporate bonds
While bonds are considered a safe investment, a trader or investor should be aware of some of the risks and pitfalls of investing in these securities. Below are 6 major risks of investing in bonds:
Bond prices and interest rate
There is an inverse relationship between bond prices and interest rates. This means that when the interest rates drop, the prices of bonds go up. This is an important concept to know if you want to know how to trade government bonds. When the interest rates increase, the price of bonds drops.
This happens because investors try to lock the highest rates for as much time as they can. To do this, they buy available bonds at interest rates that are higher than those in the market. Higher demand leads to higher bond prices. However, if the market interest rates were high, investors drop bonds with lower interest. This causes bond prices to drop.
Bond period and inflation
Buying a bond means that an investor is committing to getting a rate of return for bond duration or for the period it has been held. This rate of return can be variable or fixed. However, inflation and living costs can increase rapidly at a rate higher than the returns. When this happens, a trader’s purchasing power suffers a decline and may even result in negative returns. Because bonds are held for a certain period before their maturity, remember to factor in potential inflation when investing.
To avoid loss of returns, some traders opt for short-term bonds instead of long-term bonds.
Risk of reinvestment
The financial markets come with various risks. Bond investors suffer the risk of reinvestment. This happens when a trader has to reinvest their proceeds at lower rates than the previous yield. This risk is mainly evident when interest rates drop and issuers exercise callable bonds, meaning the bond issuer redeems the bond before its maturity. This results in the bondholder (investor) receiving the principal amount, which is higher than the par value.
However, the investor is left with money that they cannot reinvest to get a similar return, which can greatly impact a trader’s returns in the long run.
When buying a bond, an investor is buying a debt certificate. This means that the bond issuer has borrowed money from the investor and has to repay it after a specific period with interest. Many traders are not aware that corporate bonds do not have full faith guarantee from the government but depend on the ability of the corporation to repay. When buying a bond, consider the risk of the issuer defaulting.
Before investing, analyze the income of the company, its operating cash flow, and income then check this against its debt. When a company’s operating income is greater than its debt, investing in its bond is safe.
Bond rating downgrade
The ability of a company to run and repay debt is evaluated and rated by institutions like the Standard & Poor. Ratings range from “triple-A” for credit repayment to “D” for default. Investors consider these results before buying bonds. If the ability of a company to repay and operate is in question or its credit rating is low, lending institutions may charge high interest rates for loans. This can affect the ability of the company to settle current debts with bondholders and hurt their investments.
While government bonds have a ready market, corporate bonds do not. An investor faces the risk of not being able to sell corporate bonds fast because of a lack of sellers and buyers. When a bond issue has low buying interest, price volatility is likely to happen. This hurts the return of a bondholder. To sell such a bond, an investor may have to take a lower price to sell their position.