The Retirement Corporation of America

The Risks of Owning Bonds

AS A RULE, bonds are generally considered safer investments than stocks. But investing in bonds is still fraught with all sorts of dangers to your financial wealth.

To help you understand what those risks are all about, here's what they are in order of importance. Or, to put it another way, these are the risks you're taking on when you buy bonds ranked by how much of an impact they can have on your investment, from the most to the least.

Along with each risk, here is the investment strategy you should be following to minimize it as much as you can. In some cases, there is more than one investment strategy that will help you lessen a particular kind of risk.

Each strategy is intended to help you learn how to add bonds to your portfolio in a way that gives you a good chance of increasing your return from all your investments put together—but exposes you to the smallest amount of additional risk.

Type of Risk #1: Rising Interest Rates

This is a form of market risk. It and rising inflation are the two biggest risks of owning bonds. That's why we touched on them at the very beginning of this lesson. It bears repeating:

•  When interest rates rise, bond prices fall.

•  When interest rates fall, bond prices rise.

Sure, rising interest rates also tend to hurt stocks. But bonds really take a beating. Conversely, lower rates typically help stocks. But they tend to help bonds even more.

Keep in mind that the longer a bond's maturity, the more interest-rate risk you're taking on when you buy it. That's why short-term bonds pay the lowest yields. They're considered the safest. Long-term bonds are the riskiest and intermediate bonds are where you'd expect them to be, somewhere in the middle.

•  Strategic Response #1 to rising interest rates. Buy intermediate-term bonds. Stick with bonds that will mature in about 10 years. Their yields are almost as high as the yields on long-term bonds. But the prices of intermediates are much less volatile. If interest rates rise, you can reinvest the money you get as your bonds mature at those better rates. But if interest rates go up and you're locked into a 20- or 30-year bond, your only choice is to hang on, or sell the bond at a loss.

•  Strategic Response #2 to rising interest rates. "Ladder" your maturities. Buy bonds with maturities of, say, two, three, four and 10 years. Because your longer-term bonds are likely to have higher yields than the shorter-term bonds on your "ladder," the strategy should boost your overall yield. Laddering maturities also helps smooth out the effects of changes in interest rates because those changes affect longer-term bonds more than shorter-term ones.

•  Strategic Response #3 to rising interest rates. Spread your risk over just two bond investments. You might buy one 30-year Treasury bond and one three-year Treasury note, which won't be hurt nearly as much as your 30-year Treasury by an increase in rates. This is called a "barbell" strategy. You can achieve the same result by buying two bonds that have different credit ratings, one higher than the other. You might buy one top-quality corporate bond with a triple-A rating and another, lower-quality corporate bond with just an A or Baa rating. The lower a bond's credit rating, the more its price tends to fall when interest rates go up.

Type of Risk #2: Rising Inflation

As we mentioned, this is the other kind of market risk that can be devastating to bond investors. It's something you really have to worry about if you are planning to buy bonds and use their income to live on.

Even a whiff of higher inflation causes both your principal and your interest to begin losing purchasing power. The bond market responds instantly to higher inflation, long before you begin to see evidence of it in rising prices. In fact, bond prices begin to suffer when there is only the expectation that inflation might be heating up.

What the bond market likes to see is steady, sustainable economic growth. This kind of moderate growth also benefits companies and state and local governments that issue bonds because it makes them stronger financially. But a rapidly growing economy can bring on higher inflation. That's why good news for the economy is often bad news for bonds.

Watch what happens to bond prices when the government reports a big increase in job growth or housing starts. Bonds prices typically fall as soon as those reports come out—on fears they could mean that higher inflation is just around the corner.

The strategies you should use to minimize inflation risk are essentially the same ones you'd use to minimize the risk of rising interest rates. That's because one very often leads to the other.

•  Strategic Response #1 to rising inflation: Buy the inflation-indexed Treasury securities you learned about earlier in this lesson. Since their rates are tied to increases in the Consumer Price Index, your interest and principal keep their value because your investment is keeping pace with the cost of living.

•  Strategic Response #2 to rising inflation: Again, stay with intermediate-term bonds. They will give you the highest yields in exchange for the amount of inflation risk you're assuming when you purchase them.

•  Strategic Response #3 to rising inflation. The "ladder" or "barbell" strategies we've just been talking about.

Type of Risk #3: A Long Holding Period

Besides exposing you to the ravages of higher interest rates and higher inflation, buying a bond with a long holding period has another danger. It increases the possibility you may have to sell the bond before it matures—when prices are down.

•  Strategic Response to a long holding period. Again, stay with intermediates to get the best yield with the least risk. Most people don't keep the bonds they buy more than 10 years anyway.

Type of Risk #4: A Call

Pay close attention to the "call" or "redemption" provisions of a bond. If you're counting on a certain level of income for the bond's life, you don't want to have it yanked away from you before maturity.

But that's often just what happens. It's usually done when interest rates fall—the issuer calls in its old, higher-interest bonds and issues new ones at lower rates. It can also be done through a "sinking fund", which lets the issuer retire a certain number of its bonds each year. Some bonds allow for special redemptions. That might be the case when the project they're being sold to finance falls through, for example.

Bonds that are callable tend to pay higher yields than bonds that aren't to compensate investors somewhat for the risk that they may be redeemed early. But that higher yield often isn't enough to get investors to buy callable bonds. To attract buyers, an issuer of callable bonds may also set the call price (the price the issuer agrees to pay holders if their bonds are called) higher than the bond's face value. For example, a $1,000 bond, callable in 15 years, might have a call price of $1,075. The difference between the call price and the principal is the call premium.

Every bond spells out when it can be called and what you will get if that happens. If you bought your bond at par, you will get your principal back and often a little extra. If you paid more for your bond than the call price, you suffer a capital loss. Either way, a call often means you will have to reinvest the income you'd been getting from your bond at a lower rate.

Corporate bonds specify whether they can be called and under what conditions. Some municipal bonds can also be called. Always ask what a bond's call provisions are before you buy. When you buy a callable bond, your total return is your yield to first call instead of yield to maturity since the bond may be redeemed early.

•  Strategic Response #1 to call risk. Buy Treasuries. They are almost always not callable in less than 25 years.

•  Strategic Response #2 to call risk. Buy older bonds selling at discounts from their par values in the secondary market.

•  Strategic Response #3 to call risk. Buy zero-coupon bonds that are only callable at par.

Type of Risk #5: A Credit Rating Downgrade

The companies that rate bonds will lower the rating on a corporate or a municipal bond if the issuer runs into financial problems that seem likely to endanger its bondholders. When a company or a municipality's financial condition improves, it earns back its higher rating.

•  Strategic Response to a credit rating downgrade. Hang in there as long as you keep getting your interest payments on time. If you sell, you're likely to suffer a capital loss because the price of a bond that's been downgraded usually falls to reflect that it's become a bigger credit risk.

Type of Risk #6: Default

If you buy anything other than Treasuries, there's always the possibility your bond's issuer will fail to make its interest payments on time, miss a payment or even go belly-up and you'll never get your principal back.

•  Strategic Response to default risk. Stick to the good-quality bonds. If you don't buy Treasuries, buy only corporate or municipal bonds that are considered "very strong" credit risks. They are bonds rated at least Aa by Moody's or AA by S&P, Fitch and Duff & Phelps.

Type of Risk #7: Event Risk

The event might be a corporate takeover. It might be a merger, a leveraged buyout, or an internal corporate restructuring of some kind. All of these events can be bad news for bondholders. A traumatic corporate event can push down the prices of a company's bonds very suddenly. When RJR Nabisco went private in a leveraged buyout that was emblematic of the buyout binge of the late 1980s, the value of its bonds fell 20% overnight.

•  Strategic Response to event risk. Before you buy a bond, read the rating company's complete report to see if you could be vulnerable to some kind of event risk. Once you own the bonds, keep up with what the company's doing. Read its financial reports and keep track of news about it in the press. Make it a habit to check every six months to be sure its bonds aren't on Moody's "Under Review" list or S&P's "CreditWatch" because they may be downgraded.