Are Your Bonds Safe?
Jane M. Young
Let’s compare some differences between stocks and bonds. When you buy a bond you are essentially lending money to a corporation or government entity for a set period of time in exchange for a specified rate of interest. When you invest in the stock market you assume an ownership position in the company whose stock you are purchasing. As a result, the value of your investment will fluctuate based on the profit or loss of the underlying company. With the purchase of a bond the value of your investment hould not fluctuate based on the financial performance of the issuer, assuming it remains solvent. You will continue to receive interest payments according to the original terms of the agreement until the bond matures. Upon maturity the amount of your original investment (principal) will be returned to you along with any interest that is due. As a general rule, stocks are inherently more risky than bonds, therefore investors expect to receive a higher return.
Bonds may appear to be safe but they are not without risk. Currently, there is some risk associated with low interest rates that may not keep up with inflation. This is especially true with many government bonds. Two additional risks typically associated with bonds include default risk and interest rate risk.
Default risk is the risk that the issuer goes bankrupt and is unable to return your principal. Most bond issuers are assigned a rating to help investors assess the potential default risk of a bond. Generally, investors are compensated with higher interest rates when taking a risk on lower rated bonds and receive lower interest rates on higher rated bonds.
Interest rate risk is based on the inverse relationship between interest rates and the value of a bond. When interest rates increase the value of a bond will decrease and when interest rates decrease the value of a bond will increase. If you hold an individual bond until maturity your entire principal should be returned to you. You have the control to keep the bond until maturity and avoid a loss. However, if you need to sell before maturity you may lose some principal. The loss of principal is greater for longer term bonds. This needs to be weighed against the benefit of a higher interest rate paid on longer term bonds.
Bond mutual funds can provide diversification and reduced default risk because your money is pooled with hundreds of other investors and invested in bonds from a large number of different entities. If one or two entities within the mutual fund go bankrupt there will be minimal impact on each individual investor. However, with mutual funds you have less control over interest rate risk. When interest rates increase, bond fund managers often experience a high rate of withdrawals forcing them to sell bonds at an inopportune time. This usually results in a loss of principal, the severity of which is greater for longer term bond funds.