Think Bonds Are Risk-Free? Think Again

Feb. 25, 2014 -- Bonds are widely viewed as a low-risk investment that can fortify overall portfolios against the ups and downs of stocks. Yet, while they can reduce risk to portfolios through diversification, bonds themselves present risks that most investors aren't aware of.

A bond is a contract between an investor and a borrower (a company, government or government agency) calling for the investor to lend that entity money for a set time period at a set rate of interest. If you hold a bond to the end of this period (called maturity), the borrower then pays you the amount you invested plus the interest (known as the coupon).

Like any asset class, bonds have distinct advantages and disadvantages. These days, the disadvantages are mounting, as interest rates have begun to creep upward. This upward movement — and the fact that, after years of historically low interest rates, they have nowhere to go but up — suggests that further increases are probably in the cards. Rising interest rates tend to punish holders of existing bonds, so many investors are understandably skittish about bonds these days.

Contrary to the conventional wisdom that everyone should have bonds in their portfolios — in greater amounts as they age and approach retirement — bonds aren't for everyone. Whether they are for you depends on what role you reasonably expect them to play in your portfolio. To consider this, you need to understand bond risks. These include:

• Credit (or default) risk. Bonds with good credit quality — known as investment-grade — are generally considered to be among the planet's safest investments, but nothing is absolutely guaranteed. And many bonds don't have good credit. Regarding corporate bonds (those issued by companies to raise investment capital), you should rely on credit ratings, an alphabet soup that starts with AAA and goes down from there. Any bonds with credit ratings of BB or below are considered junk bonds because of their relatively high risk of default compared with investment-grade bonds.

Credit quality is critical. With stocks, most people recognize the risk that their value will go down but they are unaware that bonds also hold that same risk. High credit risk means you may never recoup your initial investment, much less receive the interest you were guaranteed. Junk bonds are highly speculative — not a place where the average individual investor should be. So it's a good idea to avoid junk and instead invest in investment-grade corporate bonds, and U.S. agency bonds, which, though they pay low rates, have the lowest credit risk of any bond.

• Interest rate risk. As the interest rates of new bonds reflect the economy's prevailing rates, new bonds issued during such periods pay higher rates than those issued when rates were lower. So, if you own a bond that pays 3 percent when new bonds are being sold at 5 percent, this means your bond is worth less, should you choose to sell it. If you choose to hold on to a bond of good credit quality until maturity, you'll probably get your money back plus the interest. But if the bond has a long term — for example, 30 years — and prevailing interest rates ratchet up high enough, you could be losing because of inflation, which tends to rise with interest rates. Let's say you have a 10-year, $1,000 bond that pays 3 percent annually. Every year, you'll receive $30 in interest, and at the end of the 10 years, you'll get your $1,000 back.