Fixed income is generally considered to be a more conservative investment than stocks, but bonds and other fixed income investments still carry a variety of risks that investors need to be aware of. To help you understand these risks so you can decide if bonds and fixed income investments are right for you, here’s what you need to know about the risks of investing in fixed income and bonds.
Interest rate risk
Investors don't have to buy bonds directly from the issuer and hold them until maturity. Instead, bonds can be bought from and sold to other investors on what's called the secondary market. Bond prices on the secondary market can be higher or lower than the face value of the bond depending on the economic environment and market conditions—both of which can be affected significantly by a change in interest rates.
If interest rates rise, bond prices usually decline. That's because new bonds are likely to be issued with higher yields as interest rates increase, making the old or outstanding bonds less attractive.
If interest rates decline, however, bond prices usually increase. This means an investor can sometimes sell a bond for more than face value, since other investors are willing to pay a premium for a bond with a higher interest payment, also known as a coupon.
If you decide to sell a bond before its maturity, the price you receive could result in a loss or gain depending on the current interest rate environment. The longer a bond's maturity—or the longer the average duration for a bond fund—the greater the impact a change in interest rates can have on its price.
Credit risk
Bonds carry the risk of default, which means that the issuer may be unable or unwilling to make further income and/or principal payments. In addition, bonds carry the risk of being downgraded by credit rating agencies, which could have implications on price. Most individual bonds are rated by a credit agency such as Moody's® or Standard & Poor's (S&P 500®) to help describe the creditworthiness of the issuer or individual bond issue.
Credit risk of Treasury bonds
US Treasury bonds have backing from the US federal government and, as such, are considered to have an extremely low risk of default—though Treasury bonds can be downgraded from their top‐notch status in times of economic or political difficulty. Since all bonds are evaluated relative to Treasury bonds, this can affect the credit quality of other generally highly rated bonds, such as government agency bonds.
Credit risk of investment grade vs. non-investment grade bonds
Bonds are typically classified as investment grade quality (from medium to the highest credit quality) or non-investment grade (commonly referred to as high-yield bonds). Bond funds and bond ETFs are not themselves rated by the agencies, but the investments they hold may be. You can find out the quality of a fund's investments by reading the fund's prospectus.
Credit risk is a greater concern for high‐yield or non-investment grade bonds and bond funds that invest primarily in lower‐quality bonds.
Credit risk of bond funds
Some bond funds may invest in both investment grade quality and high‐yield bonds. It's important to read a fund's prospectus before investing to make sure you understand the fund's credit quality guidelines.
Since bond funds and bond ETFs are made up of many individual bonds, diversification can help mitigate the risk that any single issuer defaults or is downgraded. An investment grade bond fund will typically have no less than an 80% allocation to investment grade bonds; whereas a high-yield bond fund will typically have the majority of the portfolio's assets invested in non-investment grade bonds.
Credit risk of CDs
In the case of certificates of deposit (CDs), including the brokered CDs that Fidelity offers, the presence of FDIC insurance protects investors from the credit risk of the issuer providing their total investment in that issuer remains under $250,000, per holder, per account type. Any investment amount beyond the $250,000 FDIC insurance protection is subject to credit risk and potential loss for the investor if the issuing bank or financial institution declares bankruptcy.
Inflation risk
Inflation risk is a particular concern for investors who are planning to live off their bond income, though it's a factor everyone should consider. The risk is that inflation will rise, thereby lowering the purchasing power of your income.
To combat this risk, you may want to consider US Treasury Inflation-Protected Securities (TIPS). TIPS are Treasury-issued bonds with principal values that rise in line with inflation. Because the interest they pay is tied to that principal value, the dollar amount of their interest payments rises with inflation as well. There are bond funds that invest exclusively in TIPS, as well as some that use TIPS to offset inflation risk that may affect other securities in the portfolio.
Call risk
A callable bond has a provision that allows the issuer to call, or repay, the bond early. If interest rates drop low enough, the bond's issuer can save money by repaying its callable bonds and issuing new bonds at lower interest rates. If this happens, the bondholder's interest payments cease and they receive their principal early. If the bond holder then reinvests the principal in a bond of similar characteristics (such as credit rating), they will likely have to accept a lower interest payment (or coupon rate), one that is more consistent with prevailing interest rates. Therefore, the investor's total return will be lower and the related interest payment stream will be lower—a more serious risk to investors dependent on that income.
Before purchasing a callable bond investors should evaluate not only the bond's yield to maturity (YTM) but also take account of the yield to call or the yield to worst (YTW). Yield to worst calculates the worst yield from the 2 potential outcomes—either that the bond runs through its stated maturity date, or is redeemed earlier.
Prepayment risk
Some classes of individual bonds, including mortgage-backed bonds, are subject to prepayment risk. Similar to call risk, prepayment risk is the risk that the issuer of a security will repay principal prior to the bond’s maturity date, thereby changing the expected payment schedule of the bonds. This is especially prevalent in the mortgage-backed bond market, where a drop in mortgage rates can initiate a refinancing wave. When homeowners refinance their mortgages, the investor in the underlying pool of mortgage-backed bonds receives their principal back sooner than expected, and must reinvest at lower, prevailing rates.
Liquidity risk
Liquidity risk is the risk that you might not be able to buy or sell investments quickly for a price that is close to the true underlying value of the asset. When a bond is said to be liquid, there's generally an active market of investors buying and selling that type of bond. Treasury bonds and larger issues by well known corporations are generally very liquid. But not all bonds are liquid; some trade very infrequently (e.g. municipal bonds), which can present a problem if you try to sell before maturity—the fewer people there are interested in buying the bond you want to sell, the more likely it is you'll have to sell for a lower price, possibly incurring a loss on your investment. Liquidity risk can be greater for bonds that have lower credit ratings (or were recently downgraded), or bonds that were part of a small issue or sold by an infrequent issuer.
How to help reduce the risks of investing in bonds and fixed income
A key strategy for helping to reduce the risks of investing in bonds and fixed income is diversification. Investors can diversify their bond investments by choosing bonds that vary in terms of these characteristics:
- Issuer type, such as whether a bond is issued by the federal government, a state or local government, or a corporation
- Duration, or sensitivity to changes in interest rates
- Credit quality and yield, as higher-rated bonds and lower-rated bonds may perform differently in different market environments
- Interest rate risk: Because the future direction of interest rates cannot be predicted with absolute certainty, investors in individual bonds may be able to mitigate this risk by structuring their bonds to mature at regular intervals into the future in what is known as a bond ladder formation.
Read Viewpoints on Fidelity.com: Why diversification matters
Individual bonds vs. bond funds vs. bond ETFs
Bond mutual funds and ETFs may also provide professional diversification at a lower initial investment. But the securities held in bond funds are all still subject to several risks, which can affect the health performance of a fund or ETF. Some of the key differences to understand between investing in bonds, bond mutual funds, and bond ETFs include the following:
Liquidity
Liquidity risk can be more exaggerated with an individual bond. In certain cases there may not be an active 2-way market for a specific bond and the price discovery process could take several hours. With a bond fund, on the other hand, the investor has access to buy or sell at the end of the day, and with a bond ETF, throughout the market trading day.
Return of principal
With individual bonds, an investor will be paid the bond's par value when the bond matures (provided the issuer does not default). A bond fund or bond ETF, on the other hand, does not mature and its value will fluctuate. While a bond's price can fall, the investor has an option to wait until it matures or is redeemed.
Income predictability
The future cash flows of an individual bond from coupons and principal payments are contractually transparent and can be predicted—with the caveat of default risk. With a bond fund or bond ETF, because the underlying holdings are bought and sold, the income that they generate in the aggregate will fluctuate over time and is unknowable in advance. Defined-maturity bond funds and ETFs attempt to bridge the gap between bond funds and individual bonds and offer more predictability of income than traditional bond funds. Such funds "mature" on a specified date, at which time the proceeds are distributed to shareholders.
Should you invest in bonds?
Many investors find that it makes sense to hold some bonds as part of their long-term asset allocation . Whether bonds are right for you, or how much you should hold in bonds, may depend on your goals, time horizon, risk tolerance, and risk capacity.
If you need help deciding whether bonds should be part of your investing plan, or just making a plan in the first place, learn more about how we can work together.
Read Viewpoints on Fidelity.com: Asset allocation: What it is and how to develop one and see Wealth Management