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How Risky Are Bonds?

Michael Singer - Wednesday, February 03, 2016

Usually, bonds are hailed as “safe.” As you buy bonds, you’re really lending money to an entity — the United States government, say, or company or municipality — for an established time period at a fixed interest rate. The borrower, at the end of the term, has to fully pay back the obligation.

However, bond investors are faced with numerous risks. Below includes a list to understand.

Interest rate risk: These affect bond prices. If you see that interest rates are rising, it’s possible to count on your bond mutual fund or individual bond declining in value. Here is how it’ll work: If you have a 10-year United States government bond paying 5 percent, it’ll now be worth more, as new bonds issued by the government are just paying around 2.2 percent. On the other hand, if the bond is paying 2 percent and your friend purchases a new bond that pays 5 percent, no one is going to be interested in the bond and its price will dip.

Credit risk: It’s the risk of default or the entity doesn’t repay you at the end of a term. That’s a low risk if the entity includes the United States government, yet may be a high risk if the bond was issued by a city, company, or government entity which is in trouble — for instance, consider the issues that Puerto Rico and Detroit experienced, or think about a small energy business which has to have oil to trade at $50 to pay back loans.

Inflation risk: The amount paid out, even if the bonds are completely paid off, may be worth less over time, because of inflation. A sudden rise in inflation might eat into the fixed payment stream which bonds offer.

Why does Risk Matter?

Because bonds generate a constant income stream, most investors see them as the ideal retirement vehicle. However, as aforementioned, bond prices may fluctuate. For the broad bond market, the worst calendar year was 1994, as returns were negative 2.9 percent, because of an unexpected upward change in interest rates.

So you may in fact lose money within the bond market, though the magnitude of the fluctuations is usually smaller than the ones in stocks and additional riskier asset classes.

In the coming months and years, odds are that rates are going to increase. That doesn’t mean you ought to avoid bonds altogether, yet you might want to be cautious of the kinds of bonds you place in your portfolio. If you aren’t just utilizing a broad based bond index fund, you should stick with higher-quality and shorter-duration bonds, which still can have a stabilizing effect upon a diversified portfolio over a period of time.

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