Understanding the risks of owning bonds
June 6, 1998 - © Copyright 1998 Sheldon M. Bell
The two most important financial risks of investing in bonds are default risk and market risk.
Most investors when thinking about bond risk consider only default risk, and ignore the market risk of owning bonds.
Default risk is the risk of an issuer not fulfilling the obligation to pay the ongoing interest payments due on the bond to the bondholder. It can also mean the risk of the issuer not paying back the principal to the bondholder on the maturity date of the bond.
U.S. Treasury bonds do not have default risk as they are the direct obligation of the U.S. Government. The U.S. government unlike a private corporation or a municipality can always print money or raise taxes to cover their debts, so they are referred to as riskless bonds.
U.S. Treasuries along with all other types of bonds do expose investors to what is known as market risk. Market risk is the risk of the bond losing value before the maturity date.
Future inflation expectations effect the interest rate environment that bond investors demand, and as such, the price of existing bonds that trade in the bond market. Most bonds have a fixed coupon rate which is actually the yield based on the bond selling at par, or 100% of it’s value. If bond prices fall due to selling pressure by investors then the new bondholders will receive a higher yield than the coupon.
Conversely, bond prices can rise due to buying pressure, providing the new bondholders with a lower yield than the coupon rate.
Since all bonds are not exempt from market risk, it is important to ladder the maturities of the bonds you own to accommodate your cash flow needs in the future. You do not want to have to sell off any of your bonds when interest rates are rising as you will lose some of your principal.