Bond Basics: The Ins & Outs of the Bond Market Part 3— Risks and Rewards!
Today we dive into bonds! Learn about the various risks and rewards of bonds, so you can better understand your investments.
Bonds are traditionally used to diversify and mitigate volatility in a portfolio of equities and provide income to bondholders. For those who get nauseated from the unpredictable roller coaster ride the stock market can take us on, bonds historically have done a great job of smoothing out the highs and lows for investors.
Bonds are not without their unique risks though. As the Fed moves to tame inflation by raising interest rates, many investors have seen some uncomfortably large decreases in the value of their bond portfolios and are learning firsthand that bonds are also not without risk.
Below are some of the risks that can affect the value of bonds.
Interest Rate Risk
- Bonds that have a fixed Coupon Rate based on the value of the bond (say an annual payment of $60 for a $1,000 bond equaling 6%) will end up selling for a discount if interest rates rise, because bond issuers will then start paying a higher coupon rate in line with the new rates. The bond’s value will decrease to match the equivalent coupon yield of the new interest rates.
- In the example above, if equivalent bond coupon rates rise to $80 or 8%, the bond’s value would drop to $920.15 if the Yield to Maturity (YTM) was five years.
- Bonds with longer Maturities are more sensitive to interest rates, the example above with a 10-year YTM would only be worth $865.80 if rates went up to 8%.
- The good news is, when interest rates drop, the opposite is true: the bonds then sell at a premium because they are paying a higher coupon rate than the new low-interest rates demand, thus increasing the bond’s value.
- Bonds that have low coupon payments may end up failing to keep up with the rate of inflation, particularly bonds with a longer YTM that locks the investment return at a lower yield than is needed to keep up with inflationary pressures.
- This can be overcome with I-Bonds and TIPS (see Bond Basics, part 2).
- When interest rates fall, a bond that had an original coupon rate issued in a higher-rate environment that matures will not be able to be purchased at the previous rate, which can reduce income that the investor has become accustomed to. This may also require a bond to be purchased at a premium to attain the previous income offered by the redeemed bonds.
- Another hazard of falling interest rates is if you have a callable bond. In this case the issuer can call the bond before it matures and reissue the bond at a lower rate, resulting in a lower coupon payment. Typically, a callable bond has a call date, which is the first date that the bond can be called or redeemed.
- A non-callable bond can alleviate this risk, but typically involves added initial cost for this protection.
- Generally, when payments are stopped due to financial insolvency of the issuer, this is considered default. The issuer may not be able to redeem the bond at maturity as well due to the financial hardship of the issuer. Corporate bonds and municipal bonds are subject to this sort of risk, with high-yield or junk bonds particularly susceptible to default, which is why they pay a higher rate.
- In contrast, treasury bonds and other fixed-income securities issued by the federal government are considered safe from default risk.
Despite these risks, the benefits of bonds:
Despite these risks, Bonds have a place in many investors’ portfolios.
- The volatility of bonds has historically been much lower than that of equities or stocks.
- A bond investor can choose an investment that pays out a specific coupon and has a specified value upon redemption at maturity regardless of interest rates that rise and fall over the lifetime of the bond.
- Bondholders are also prioritized in a bankruptcy proceeding, getting paid before stockholders in a company liquidation.
- Bond Basics: Understand the Ins and Outs of the Bond Market, Part I
- Bond Basics: Understand the Ins and Outs of the Bond Market, Part 2
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