Think Bonds Are Risk-Free? Think Again

Do bonds still have a place in your investments?

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.

• Inflation risk, although related to interest rates, is slightly different. If inflation has run at 5 percent, consistent with the rise in interest rates during that period, you'll have less buying power and be unable to sustain the same cost of living that you had 10 years ago when you purchased the bond. Thus, your standard of living can easily be cut because your return on the bond didn't keep up with inflation.

Falling interest rates have the opposite effect. If you buy a bond with a coupon paying 5 percent and prevailing interest rates move downward on new issues your bond is worth more. That happened during the '90s and 2000s, enabling holders of existing bonds to sell them for more than they'd paid. This decline in rates was followed by a long period of low interest rates but low inflation. Even though bonds paid low rates during this period, investors benefited from low inflation and long-term bond holders also gained from declining interest rates.

Interest rate risk is inherent in bond funds, where investors buy shares in pooled investments (like mutual funds) that own many bonds. When you own a government agency bond, backed by the full faith of the government, or an investment-grade corporate bond, you can always hold it until maturity and thus get all the interest, plus your intitial investment.

If the duration isn't too long and you bought wisely (aware of the economic forecasts at the time), you probably won't suffer much from inflation risk because inflation will be offset by the interest you collect at maturity. But with bond mutual funds, which hold dozens or even hundreds of bonds, you can't get to this point because fund managers sell their funds' bonds before maturity to create liquidity for investors redeeming shares and to justify their existence as active managers. So bond funds are valued at the end of each day, reflecting the value of the underlying instruments they hold--as such you can't wait until maturity to collect your full investment. In addition, bond funds have a tendency to be volatile. For these reasons, I generally don't recommend bond funds no matter what interest rates are doing.

Now that interest rates are pointed upward, this is a particularly bad time to be in most bond funds, as managers must sell holdings at a discount. To compensate for the lower returns that result from these discounted sales and the damage to fund shares from too much turnover, some bond fund managers may compromise on credit quality by buying lower-rated bonds including junk, increasing credit risk for investors. Most bond funds are a treacherous place to be right now.

• Longevity risk. With investing in general, this is the long-term risk of not getting returns high enough to sustain you through retirement. To control for this risk, bond investors should avoid having too much money in long-term bonds (now that rates are on the rise, it's a good idea to limit durations to five years or less). While U.S. Treasury bonds have the best credit quality, those who over-invest in long-term Treasuries during retirement set themselves up for severe losses in buying power, increasing the risk that they will outlive their money.

Investors also face significant longevity risk from buying the wrong corporate bonds. Recently, an elderly woman came to me with a portfolio that included long-term, low-rate corporate bonds (one of them not reaching maturity until 2052). Though she won't live until maturity — and she'll take a bath selling the bond in the secondary market because of the low rate — a large brokerage sold her these bonds out of an inventory its advisors are pressured to move (which is why I advocate a fiduciary responsibility for brokers but that is another story). Instead of finding a bond that suits her needs, the firm unloaded these albatrosses on her. In a rising-rate environment, this practice will become increasingly common, so be on the lookout for it.

Bonds provide income and portfolio diversification due to a weak correlation with stocks and lower volatility. Some are tax advantaged. But although they provide higher returns than CD's and savings accounts, they do not come without risk. By understanding bond risks, you will be better able to make informed decisions about whether you want to buy bonds, and if so, what type and in what amounts in the context of your needs and the prevailing interest rate environment.

This work is the opinion of the author and not that of ABC News.

Laura Mattia is a partner with Baron Financial Group, and a fee-only financial advisor. She's a Certified Financial Planner professional (CFP®), a Chartered Retirement Plan Specialist (CRPS®) and a Certified Divorce Planner (CDFA™) and holds an M.B.A. in accounting/finance. Her Internet radio show is Financially Empowering Women™ with Laura Mattia. A professor at the Rutgers University Business School, Mattia is completing a Ph.D. in financial planning from Texas Tech University; her dissertation is on how to help women plan for retirement.