4 common risks for bond investors
1. Interest rate risk
When interest rates rise, bondBond A kind of loan you make to the government or a company. They use the money to run their operations. In turn, you get back a set amount of interest once or twice a year. If you hold bonds until the maturity date, you will get all your money back as well. If you sell…+ read full definition prices fall. When interest rates fall, bond prices rise. This is a risk if you need to sell a bond before its maturity dateMaturity date The date when an investment becomes due. On that date, you get your money back without any penalty. Any interest payments stop.+ read full definition 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 investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition doesn’t keep pace with inflationInflation A rise in the cost of goods and services over a set period of time. This means a dollar can buy fewer goods over time. In most cases, inflation is measured by the Consumer Price Index.+ read full definition. 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 principalPrincipal The total amount of money that you invest, or the total amount of money you owe on a debt.+ read full definition back when your bond matures, but it will be worth less in today’s dollars. Inflation riskInflation risk The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation.+ read full definition 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 riskCredit risk The risk of default that may arise from a borrower failing to make a required payment.+ read full definition or default risk. Sometimes, the issuerIssuer An organization that offers securities for sale to investors. Examples: corporations, investment trusts and government bodies.+ read full definition can’t make the interest payments to investors. It’s also possible the issuer won’t pay back the face valueFace value What you pay to buy a bond or some other investment.+ read full definition of the bond when it matures.
Learn more about the factors that affect bond prices.
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 rateInterest rate A fee you pay to borrow money. Or, a fee you get to lend it. Often shown as an annual percentage rate, like 5%. Examples: If you get a loan, you pay interest. If you buy a GIC, the bank pays you interest. It uses your money until you need it back.+ read full definition 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-termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest.+ read full definition 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 riskInterest rate risk Interest rate risk applies to debt investments such as bonds. It is the risk of losing money because of a change in the interest rate.+ read full definition is to buy bonds that matureMature When an investment such as a bond reaches its maturity date. On that date, you get your money back without any penalty. Any interest payments stop.+ read full definition at different times. This is known as ladderingLaddering A way to invest where you spread your money across the same investment with different maturity dates. Example: With $5,000, you could put $1,000 into a 1-year GIC, $1,000 into a 2-year GIC and so on. That way you would have $1,000 of principal maturing every year for 5 years.+ read full definition. 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 bondsReal return bonds Real return bonds are issued by the Government of Canada and are also designed to keep pace with inflation. Twice a year, you receive interest payments adjusted to the CPI. When a real return bond matures, the amount you get back (the face value) is also adjusted for inflation.+ read full definition.
4 key points
Common risks of investing in bonds:
- Interest rate risk
- Inflation risk
- Market riskMarket risk The risk of investments declining in value because of economic developments or other events that affect the entire market. The main types of market risk are equity risk, interest rate risk and currency risk.+ read full definition
- Credit risk
Reduce bond risk by: