Risks of Bond Investing


August 20, 2011

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If you are thinking about investing in municipal bonds, you likely have two main investment objectives: Capital preservation and income generation.

Capital preservation means you do not want to lose any money. If you invest a dollar, you want your dollar back at the very least. Income generation means that you want to receive some ongoing interest income on a predictable basis (this is why bonds are also known as “fixed income” securities.) From your bond investments, your goal is to protect your assets as much as possible. You may have a stock portfolio, maybe you even own cattle futures, but your aim with your bonds is to protect your investment principal and sleep well.

Buy and Hold

If you are considering investing in munis, you should plan to hold the bonds to the stated maturity date. Municipal bonds are not instruments you want to buy with plans to sell the bonds prior to the maturity date. In other words, municipal bonds are buy and hold investments.

The more risk you take on, generally speaking, the higher your yield and the more income you can generate. There is no such thing as a free lunch in the bond market, so if you are able to earn a higher yield, you are generally taking on more risk. There are a number of risks to bond investing; some are not as significant as others. Others can have material consequences. We are going to focus on risks that will impact you if you plan to hold the bonds to maturity.

Credit Risk/Default Risk

This is the risk of whether the borrower, the municipal bond issuer, will pay you your interest on time and the bond’s face value upon maturity. Is it a hospital? Is it a school district? How are the bonds going to be repaid? What is the credit quality of the borrower? Each individual borrower is different. Certain categories of borrowers have historical track records worse than other categories.

Interest Rate Risk

This is the risk that if you buy long-term bonds at a given yield and interest rates become higher than you anticipated while you own the bonds. Let’s say you bought a 10-year bought at a yield of 3%. 3 years later, let’s say that interest rates on bonds 7 years out are yielding 6%. Chances are that you are bonds are worth less; you will still get paid back 100% of the face value of the bonds at maturity. If you could have predicted the appreciation in interest rates perfectly, you most likely would have been better off buying a 3-year bond and then buying a 7-year bond. Since you cannot predict interest rates perfectly, you are assuming interest rate risk anytime you buy a bond – the risk that interest rates can change.

Inflation Risk

After 5 years, let’s say the rate of inflation is 4%. Your anticipated returns might be lower on an inflation-adjusted basis. A rise in inflation can eat into long-term fixed rate investments. If you are anticipating a big rise in inflation, you need to sure that you are being compensated for the risk that you are taking. Conversely, if you expect deflation or very low rates of inflation, you may find long-term yields to be attractive given your perspective.

If you hold your bonds to maturity, meaning you do not sell them before the bonds are due, credit risk (risk of default) and inflation risk should be your primary considerations.

There is also:

Downgrade risk: what if the bonds get their ratings lowered

Liquidity risk: what if you cannot sell the bonds easily prior to maturity

Call risk: if the bonds get redeemed early (covered in later chapter)

Regulatory risk: what if the taxation rules on tax-exempt interest change

All of these other risks will influence the value of your bonds prior to maturity, but as long you hold your bonds to maturity, you will get all of your scheduled interest payments and get your principal back.

 

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