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Are Bonds Safe Investments? – Financial Rules of Thumb series

[This post is part of the Financial Rules of Thumb series.  Check out the rest here!]

“Bonds are safe”.  ”You can’t lose money in bonds”.  These and other similar statements are often made about investing in Bonds, but are they true?  Are bonds safe investments?

The Upperline: You can lose money in bonds. They’re not without risk. They have different kinds of risks than stocks, that need to be understood if you’re going to invest in them.

The price of bonds can fluctute up and down. While the prices of bonds may not move as much or as often as stocks, they do still move.  This post explores some of the risks associated with bonds.  While not a list of every risk that bonds face, below are a few basics that should be understood by the general public.

Interest Rates. If I own a bond that is paying 5%, and a similar bond is issued that now pays 6%, who would buy my 5% bond?  Would you rather get paid 5% or 6%?  When interest rates go up, prices on existing bonds tend to go down so that the yield is similar to new bonds.  The opposite is true, too.  If interest rates go down, your existing bond paying a higher interest rate is probably worth more than you initially paid for it.

Default Risk.  When you buy a bond, you’re effectively lending money to a company or government, that they pay you interest on and ultimately they repay the principal to you with the final payment.  If a company (or government) goes bankrupt, they may not be able to repay that principal to you.  Ratings agencies like Fitch and Moody’s asses the risk of a company which then affects the interest rates the company must pay to borrow money (Think of this like a credit score.  If you have a good credit score, you might pay less on your mortgage than somebody with a poor credit score).  The risk right now as interest rates are low, is that some might be tempted to purchase bonds of a lower credit quality to get higher interest payments, when they’re not aware of the extra risk they’re taking.  Risk and return are eternally linked.

Duration.  If you were going to lend somebody money for 10 years, you’d probably want a higher return on your money than if you lent them money for 3 months.  Bonds work the same way.  Bonds that are longer carry higher interest rates, and might be attractive with yields on short-term bonds as low as they are.  The risk here is that we’re near historical lows in the bond market.  It’s at least likely that interest rates will start to rise at some point and longer-term bonds will be affected more than short term bonds.  If you own a bond mutual fund, a measure of portfolio length is “duration”.  The longer the duration, the more risk of price fluctuation inside of that portfolio.

I have add this last paragraph or my friends who are financial planners will lose their mind.  Just because the value of a bond goes up or down doesn’t mean you’ve lost money.  You don’t recognize that loss as long as you don’t sell.  It’s quite possible that you can hold a bond that is trading for less than its face value, and you hold it to maturity and get the entire principal back.  This is certainly true if you own bonds directly, but it’s not as straightforward with bond funds.  If you own a bond fund and interest rates start to rise, the values of the bonds may decline, causing others to sell their shares in the fund.  That fund then may need to sell some of its bonds at lower prices than they might otherwise hope to meet those distribution requests.  It’s not a certainty, but it’s a risk that must be understood.

Want to read more?  Here’s an extensive overview of other Bond Risks from CNNMoney.

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