4 common risks for bond investors
1. Interest rate risk
When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. This is a risk if you need to sell a bond before its maturity date and interest rates are up. You may end up selling the bond for less than you paid for it.
2. Inflation risk
This is the risk that the return you earn on your investment doesn’t keep pace with inflation. If you hold a bond paying 2% interest and inflation reaches 3%, your return is actually negative (-1%), when adjusted for inflation. You’ll still get your principal back when your bond matures, but it will be worth less in today’s dollars. Inflation risk increases the longer you hold a bond.
3. Market risk
This is the risk that the entire bond market declines. If this happens, the price of your bond investments will likely fall regardless of the quality or type of bonds you hold. If you need to sell a bond before its maturity date, you may end up selling it for less than you paid for it.
4. Credit risk
If you buy bonds from a company or government that isn’t financially stable, there’s more of a risk you’ll lose money. This is called credit risk or default risk. Sometimes, the issuer can’t make the interest payments to investors. It’s also possible the issuer won’t pay back the face value of the bond when it matures.
Assessing bond risk
You can learn about the credit risk of different bonds from a credit rating agency like DBRS, Fitch, Moody’s or Standard & Poor’s. These agencies rate the issuer’s ability – in the agency’s opinion – to make regular interest payments and to pay investors back when the bond matures.
Canadian federal and provincial bonds generally have low credit risk. You’ll likely get a lower interest rate on these bonds, but there’s little chance the issuer will default on a payment. The bonds with the highest credit risk are high-yield bonds, issued by companies with low credit ratings. They pay higher interest, but there’s a higher risk you won’t receive any interest payments or get back your original investment.
All other things being equal, longer-term bonds tend to have higher returns and higher risk than shorter-term bonds. That’s because the longer you hold a bond, the more it could be affected by changes in interest rates, inflation and market declines.
2 ways to manage risk
1. Bond laddering
One way of reducing interest rate risk is to buy bonds that mature at different times. This is known as laddering. Laddering can help reduce the risk that all of your bonds will mature at a time when interest rates are low. It also frees up cash at different times, which you can choose to reinvest or use as income.
By choosing a mix of bonds with different features, you’ll increase the chance that some of your bonds will perform well at times when others do not. Consider buying a mix of bonds that fit with your financial goals and tolerance for risk. This could include a mix of government and corporate bonds, bonds that mature at different times, or more complex bonds like strip bonds or real return bonds.