For many years, fixed-income securities have been a staple of investor portfolios, assisting both savers and retirees in generating income to help them achieve their financial objectives. Due to its lower volatility, investing in fixed income is typically thought to be less dangerous than investing in the stock market. Less danger does not, however, imply no risk.
Legendary investor Warren Buffett stated in his 2021 annual letter to shareholders that “Fixed-income investors worldwide – whether pension funds, insurance companies, or retirees – face a grim future.” Bonds are no longer the place to be, he declared.
You will be taking a certain amount of risk with any fixed-income investment you make, whether you choose to invest in corporate or government bonds or other fixed-income instruments like certificates of deposit.
Let’s examine some of the major dangers associated with fixed-income instruments.
1. Credit risk is
Your return as a bond investor will come from the timely payment of coupons and principal, the reinvestment of those coupons, and any gain or loss if you choose to sell the bond before it matures.
Credit risk is the possibility of suffering a loss if the bond issuer fails to make the necessary principle and interest payments on schedule or at all. An issuer is deemed to be in default when a payment is missed. For enterprises or governments, financial success or even solvency isn’t a given, and occasionally there isn’t enough money to pay off their debts. In the event of a default, bondholders are typically not fully destroyed, but the final effect depends on how quickly investors recover their investment.
Bond investors face a number of hazards, including credit risk, but there are also other credit-related concerns to be aware of, some of which are included below.
2. Spread risk
Bonds that are thought to be free from the danger of default, like U.S. Treasury bonds, often trade at a yield premium to bonds issued by corporations or other organizations that bear credit risk. If the issuer’s creditworthiness or the bond’s liquidity drop, this yield premium, or spread, may grow, which will lower the bond’s price.
3. Reduced risk
This refers to the possibility that a bond issuer’s creditworthiness would deteriorate, driving up its yields and driving down bond prices. Downgrade risk is so named because declining creditworthiness would probably lead to the bond’s rating being lowered or downgraded by major rating agencies including Moody’s, Standard & Poor’s, and Fitch.
4. Liquidity risk, fourth
This risk arises when the price at which a bond can actually be purchased or sold differs from the market price. Bonds having liquidity risk typically trade at higher yields than otherwise identical bonds because investors may not be able to buy or sell them in the amount they desire.
Liquidity risk is often lower for issuers with a substantial amount of outstanding debt and higher for issuers with weaker credit ratings. Because investors are less inclined to participate in the market during times of crisis or market panic, liquidity risk can also rise.
5. Risk of inflation
Because inflation may reduce the final return received by fixed-income investors, they pay particular attention to this issue. If inflation is 3 percent or greater, a bond with a 2 percent yield will hurt investors. Interest rate levels typically take inflation projections into account, although perceptions can swiftly shift and cause rates to rise or fall.
Bond prices have benefitted from declining interest rates for many years. A 10-year U.S. Treasury bond yielded approximately 16 percent to investors in 1981. Since that yield has decreased dramatically over the past forty years, some market observers fear that the best days for bond investors may be behind us.
6. Interest rate uncertainty
The danger of an increase or decrease in interest rates is another significant risk involved with fixed-income investing. Rate changes have an effect on bond investors because they alter the rate at which coupon payments can be reinvested and because they alter the market price of the bond if the investor wants to sell it before the bond matures.
Bond prices reduce as interest rates rise, but since rates have been steadily falling for decades, some investors may forget or overlook the hazards associated with fluctuating interest rates.
7. Risk of reinvestment
The probability that you won’t be able to reinvest a bond’s coupon payments at a rate that is comparable to the current return is referred to as this risk. Because dropping interest rates will raise the bond’s market price, this risk can be somewhat reduced. High coupon rates and lengthy reinvestment periods are associated with the highest reinvestment risk.
Reinvestment risk is another aspect of CDs, as you might not be able to reinvest the funds at the same rate after they mature. However, as most CDs require you to leave your money alone until the term is up or face an early withdrawal penalty, you won’t be able to benefit from the higher return if rates rise after you’ve bought the CD.
8. Price hazard
The effect of fluctuating interest rates on the bond’s market price is referred to as price risk. The most vulnerable bondholders to price risk are those with shorter time horizons, including short-term speculators, who may sell a bond before they even receive a coupon payment.
- To sum up
Although fixed-income trading may be less volatile than stock market investing, this does not imply guaranteed profits or zero risk.
Undoubtedly, fixed-income investments can offer investors some benefits of diversification. Investors frequently view U.S. Treasury bonds as protective, which causes their prices to rise during times of market stress when stocks may be sharply decreasing.
Make sure you comprehend the bond or bond mutual fund’s credit rating and consider how any changes in interest rates can affect your portfolio.