Bond Risk – Don’t take on more than you need!
I know what you are thinking. What bond risk? Surely it is stocks that are risky not bonds!
Most investors have bonds and stocks in their portfolio. Stocks provide the risky bit with juicy returns, and bonds provide the safe and stable bit at the expense of juicy returns.
Well, to be honest, some bonds provide the safety and stability, whereas others can provide juicy returns. There’s no free lunch in investing though, so the juicy returns are traded off against higher risk.
Investors tend to turn to riskier higher yielding bonds when government bond yields are low. Risky bonds give investors a chance of getting more income for their money. However, they come with bond risk.
So what are riskier bonds? The risk inherent with bonds is linked to issuer and maturity. In essence, who is borrowing the money and how long they are borrowing it for.
The risk associated with maturity is related to interest rates and inflation. The longer the bond maturity the more chance it has to be affected by interest rates or inflation. When interest rates go up, bond values go down and the higher the inflation the lower the real return. Consequently, the longer the maturity the higher the yield received.
The issuer or which company/organization is borrowing the money also adds risk. In fact, this risk is perhaps greater, because there is a possibility the company may default. A default means the bond issuer doesn’t pay when they are supposed to.
Bonds are supposed to pay out interest at regular intervals and return the principle (the borrowed amount) at a set date. Failure to complete either of these actions is a default.
I’m sure it goes without saying that defaulting isn’t a good sign. It is usually a last resort and tends to mean the company has no other option because defaulting is going to severely damage the chances of being able to borrow from anybody in the future.
Basically, companies or governments will need to be in serious trouble before they consider defaulting.
Defaults don’t necessarily mean an investor loses all their money. In some cases it does. In other cases it means some of the money is lost, but in some cases it can mean investors getting all their money back, but at a later date than agreed.
Since there is still a chance that money can be made from these bonds defaulting doesn’t mean these bonds aren’t worth anything. Typically, bonds continue to trade, but at lower prices.
Though most investors are probably better off staying away from such bonds, some experienced investors see this type of bond as an opportunity to make money.
Unless you really know what you are doing with bonds it is probably better to stick to low risk bonds and avoid high risk bonds. Bonds with a low risk of default are called investment grade bonds.
Whether a bond is considered investment grade is determined by rating agencies. A Standard & Poor’s (S&P) rating of BBB or above and a Moody’s rating of Baaa3 or above signifies investment grade (IG). Ratings below these are considered non-investment grade.
Non-investment grade bonds do have other names that are more intuitive i.e. high-yield bonds or junk bonds.
The table below shows historic default rates for Municipal (Government) and Corporate Bonds for Moody’s and S&P.
Cumulative Historic Default Rates (in percent)
Looking at the averages at the bottom, it is clear to see corporate bonds are much more risky than government bonds and non-investment grade are much more risky than investment grade.
It is probably worth reiterating that unless you know what you are doing, or are investing in a fund of which you are sure the manager knows what he or she is doing, non-investment grade bonds are going to be best avoided. In fact, many experts suggest sticking with investment grade government bonds only.
History suggests this could be a wise move. In 2008 high-yield bonds lost nearly 20%, whereas investment grade government bonds went up in value.
If you really want to increase the expected return of your portfolio, a more straight forward way may be to reduce your allocation to bonds and increase your stock allocation.
