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The Risks that Come with Bonds

A bond is a loan and when you buy one you are playing the role of lender.  A company or the government sells them and they represent a promise to pay the money back along with some additional interest over time or at the end of the agreed upon period.  Most personal investors buy shares in bond funds which are collections of these bonds, usually all of a certain type.

Are bonds, even treasury bonds, always a no to low risk investment?  Heck no.  Not even close.  Just like equities you can come out way ahead or lose your shirt and just like equities trying to time the market is a losing game.  A very large portion of bond and bond fund investments carry every bit as much or more risk than equities, specifically the ones that offer comparable expected returns.  For example if you bought shares in a highly diversified portfolio of very high quality (low default risk) long term (meaning the bonds are locked in at a specific interest rates for 20-30 years) bonds by purchasing $100,000 of the Vanguard Long Term ETF (BLV) in July of 2012 each share cost you roughly $97.  One year later it was worth around $83 losing you $14,000 of your $100,000 investment (if you had to sell at that point) due to rising interest rates in the market in that period.  In that same time period you would have only earned $438 in interest/dividends.  Not risk free.

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Bonds can be risky too.

Investing in bonds carries risks, not just stocks.

There are some bond options that are far less volatile than any stocks, but those are the ones that pay very little interest like short term treasury bonds.  To some extent bonds tend to go up when stocks go down and vice versa so they have a place in your portfolio and are especially important in late retirement.  You just need to be sure you are buying the kinds of bonds that meet your investment objectives.  This post will help you understand how to tell which is which.

Bond risk derives primarily from three sources, default risk, interest rate risk and leverage (in certain funds and ETFs).  If you are getting higher yields, today that’s anything above 1-2%, you can be sure you are assuming some of this risk.  The higher the interest paid, the more risk you should expect to see from one or all of these sources.  In the vast majority of cases, interest rate risk is a far greater consideration than default risk which can be mitigated by diversification and sticking to quality, and leverage risk is something the average passive investor should completely avoid or keep to a minimum.

Default Risk

Default risk is simple. You buy a bond which amounts to loaning a company or government entity your money or buying out such a loan from someone who has done so.  That entity can’t pay back the loan, they default, you lose some or all of what you lent.  Sounds awful, but in practice you can mitigate this risk by purchasing bonds from a variety of unrelated issuers and by sticking to high quality (and lower return) bonds that are issued by entities not likely to default (or bond funds made up of such).  Government treasury bills are generally regarded as the safest, and not surprisingly offer the lowest interest.  Ratings agencies exist to help you assess the quality of different bonds and any typical investor will want to stick to “investment grade” bonds and steer clear of lower quality “junk bonds” even if they offer tempting returns.  Given the safe options available and the ease of diversification, defaults don’t typically have a big impact on most investors.

Interest Rate Risk

Interest rate risk is a little more complicated and a lot harder to avoid when trying to earn returns significantly above the rate of inflation.  The risk derives from the fact that the “going rate” for similar bonds can fluctuate significantly over time.  If interest rates go up, the value of a bond you hold immediately goes down if you were to resell it.  For example if you buy a $10,000 bond that matures in 10 years and pays 3% a year in interest today, then a month later 10 year bonds from the same issuer are offering 4% (an extreme example), the value of your bond on the open market drops to account for the fact that it is paying below market interest rates, to about $9,160 or an 8.4% loss.  You could hold it until maturity and unless it defaults you will always get your 3% interest payment and your principal back, but you are still behind where you would have been had you bought the better bond a month later.  This effect is made even more obvious if you have a bond fund comprised of multiple binds as the NAV (price per share of the fund) will fluctuate immediately with changing interest rates.

Interest rate risk varies quite a lot by time to maturity, which given the above makes sense.  It can hurt you if interest rates rise as you are stuck with the low interest rate for a longer time, or help you when they fall as you have locked in what is now a better than market rate for a longer time.  Here are some approximate data points to give you an idea of the magnitude of fluctuation in value you will see based on years to maturity for each 1% increase in market interest rates:

  • 2-Year: -1.9%
  • 5-Year: -4.7%
  • 10-Year: -8.5%
  • 30-Year: -17.8%

When you need to mitigate interest rate risk, stick to short and maybe intermediate maturity bonds and bond funds, though you will be sacrificing returns in the form of the lower interest rates such bonds typically offer for the same quality.

Leverage Risk

Leverage can yield impressive returns and impressive losses.  This strategy is typically used in funds or REITS like for example Annaly Capital Management (NLY) which pays around a whopping 16% a year dividend.  The high returns are generated by using short term low interest loans to purchase long term higher interest bonds (in this case government insured mortgages).  So for example a company might borrow short term at 2% and buy 30 year notes with a 4% rate of return, using those notes as collateral.  The higher long term interest received is used to pay the short term interest owed netting a substantial return that multiples as more short term loans are used to buy long term notes.

This strategy works great as long as short term interest rates stay stable and low.  The risk in this approach is that short term rates are constantly changing and new loans have to be taken as short term debt comes due at the then current rate, whereas the long term rate of interest generated is locked in.  Should short term interest rates go up even a little, there is less profit left over after the returns from the long bonds are used to pay the interest on the short loans, reducing the value of the overall portfolio.  Without hedging, if short term borrowing rates go up enough over a few years to equal the interest rate paid on the long bonds purchased, the value of the whole investment can go to zero.  I have heard this strategy referred to as “picking up pennies in front of a steam roller” and I think that’s an apt analogy.

None of this translates to “don’t buy bonds”, but you need to understand the factors that drive the risks associated with different kinds of bonds and bond funds to select the right kinds of bonds for you.  Asset Class diversification (having different KINDS of investments e.g. stocks, bonds, real estate) is the key to long term returns with the lowest possible volatility and bonds are a sound component of that strategy.  It is also fair to note that bonds have historically been less volatile than equities for example as an Asset Class overall, though given we are in a period of historically low interest rates it is hard to imagine that there is not more bond risk right now than usual.

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