The Risks of Bonds

One of the main risks of a bond is the possibility that financial trouble could make the bond’s issuer unable to pay the interest or even give you back your principal as originally agreed. The issuer may even declare bankruptcy. If this happens, the issuer defaults on the debt it owes you, which can make it difficult or impossible to get all of your money back. Different issuers carry different risks. The highestquality bond issuer is the U.S. government. 

A superior credit rating makes Treasury bonds the safest investment in the world when it comes to default risk. Corporations, in contrast to government issuers, must depend on their revenues to repay their debt, which means that strong and large corporations will generally be considered better bond credit risks than smaller, less profitable companies. 

Some low-quality issuers can only offer what are called high-yield or junk bonds, which can provide high rates of interest, but also carry the risk of paying nothing at all if the issuer defaults. Bond investors are also affected by inflation. The problem here is that the interest rate bonds pay is locked in when you buy them, so if everyday prices go up too fast before the bond matures, the money you get back won’t go as far as it did when you bought the bond in the first place. Say you buy a $1,000 bond with a term of one year and a five percent coupon rate. 

When the bond matures, you’ll have earned $50 in interest. Unfortunately, if the price of everything climbs three percent during those 12 months, your $50 only has the buying power of $48.50 in next year’s dollars (this “after-inflation” value of an investment is called its real return). Furthermore, when you get your $1,000 back, its buying power will have shrunk also. You haven’t technically lost principal, but you haven’t done quite as well as it might look on paper. And if you depend on income from your bonds to pay your living expenses, you could have to cut back if faced with rising inflation. Inflation forecasts are always changing as the market receives new information about the way prices are going. 

The quality of a bond can also change if something happens to make the issuer more or less able to pay its debts. New bonds are always being issued at whatever interest rate people are willing to accept in return for the loan of their money, and old bonds are always changing hands as investors look for a better deal.