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. Diversification can be a good way to minimize many of the risks inherent in fixed income investing. In the world of fixed income, diversification takes on many forms, including diversification across bond type, bond issuer (such as the federal or a state government, or a corporation); duration (short-, intermediate-, and long-term bonds); credit quality and yield (high-quality bonds are relatively safer but pay lower rates, while less credit-worthy issuers will pay higher rates for greater risk); and tax treatment (most municipal bonds, for instance, offer investors tax-free income). Bond funds can 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 of a fund.
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, which 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. In addition, zero‐coupon bonds, or those bonds with lower coupon (or interest) rates are more sensitive to changes in interest rates and the prices of these types of bonds (or bond funds or ETFs that hold these bonds) tend to fluctuate more than higher‐coupon bonds in response to rising and falling rates. However, if you’re holding a bond until maturity, interest rate risk is not a concern.
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 the 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) to help describe the creditworthiness of the issuer or individual bond issue. U.S. Treasury bonds have backing from the U.S. government and, as such, are considered to have an extremely low risk of default —though Treasury bonds can be (and have been by S&P) 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 agency 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. 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 credit risk of an issuer defaulting or being downgraded, which would affect bond prices. An Investment Grade bond fund will typically have no less than 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.
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 U.S. Treasury Inflation-Protected bonds (TIPS). The TIPS principal is adjusted for any rise in the Consumer Price Index, so when the bond matures and the principal is returned, that amount will be higher to correspond with the amount of inflation. (TIPS do not adjust at all if inflation decreases over the life of the bond.) Because this inflation factor is a component of the interest payment calculation, interest payments for TIPS are variable, even though the coupon is fixed. 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.
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), he or she 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.
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 his or her principal back sooner than expected, and must reinvest at lower, prevailing rates.
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.
Weighing the risks of individual bonds vs. bond funds and bond ETFs
Because bond funds and bond ETFs are generally diversified across multiple securities a single purchase made with a limited investment amount can provide access to potentially hundreds of different issuers. This can help lessen the downside impact from a credit event impacting any one of the issuers.
The liquidity risk just described above can be more exaggerated with an individual bond. In certain cases there may not be an active two-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 so long as the issuer does not default an investor will be paid the bond’s par value when the bond matures. 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.
The future cash flows of an individual bond from coupons and principal payments are contractually transparent and can be predicted – with the caveat of insolvency as described above. 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.