Fixed income is generally considered a more conservative investment than stocks, but bonds and other fixed income investments still carry a number of risks that investors should be aware of. Diversification can be a good way to minimize many of the risks associated with fixed income investing and can be achieved by choosing bonds that vary in these characteristics:
Issuers, including federal or state governments or corporations
Durationor sensitivity to changes in interest rates
Credit quality and returns, because high-quality bonds pay lower interest rates, while riskier bonds often pay more
Tax treatment, which may vary depending on the issuer
Bond funds can also provide professional diversification with a lower initial investment. But the securities in bond funds are all still subject to various risks that can impact the health of a fund.
Interest risk
Investors do not have to purchase bonds directly from the issuer and hold them until maturity. Instead, bonds can be bought from and sold to other investors on the so-called secondary market. Bond prices in the secondary market may be higher or lower than the bond's face value depending on the economic climate and market conditions – both of which can be significantly affected by a change in interest rates.
When interest rates risebond prices generally fall. This is because new bonds are likely to be issued at higher yields as interest rates rise, making the old or outstanding bonds less attractive.
When interest rates fallHowever, bond prices tend to rise, which means an investor can sometimes sell a bond for more than its face value because other investors are willing to pay a premium for a bond with a higher interest payment, known as a coupon.
If a bond is sold before maturitythe price received may result in a loss or a gain depending on the current interest rate environment. The longer the term of a bond – or the longer the average term of a bond fund – the greater the impact that a change in interest rates can have on its price. In addition, zero coupon bonds or bonds with lower coupon rates (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 bonds with a higher coupon in response to rising and falling interest rates. But if a bond is held until maturity, interest rate risk is not a problem.
CREDIT RISK
Bonds carry the risk of default, which means the issuer may be unable or unwilling to make additional income and/or repayments. Furthermore, bonds run the risk of being downgraded by rating agencies, which could impact their 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 are backed by the U.S. government and as such are considered to have an extremely low risk of default – although Treasuries can be downgraded from their prime status in times of economic or political difficulty. Because all bonds have a rating comparable to government bonds, this can affect the credit quality of other generally highly rated bonds, such as government bonds.
Bonds are typically classified as investment grade (from average to highest credit quality) or non-investment grade (commonly called high yield bonds). Bond funds and bond ETFs are not rated by the agencies themselves, 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 sub-investment grade bonds, and for bond funds that invest primarily in lower-quality bonds. Some bond funds can invest in both quality bonds and high-yield bonds. It is important to read a fund's prospectus before investing to ensure you understand the fund's credit quality guidelines.
Because bond funds and bond ETFs are made up of many individual bonds, diversification can help reduce the credit risk that an issuer will default or be downgraded, which will impact bond prices. An investment grade bond fund typically has no less than an 80% allocation to investment grade bonds; while a high yield bond fund will typically invest the majority of the portfolio's assets in sub-investment grade bonds.
In the case of certificates of deposit (CDs), including the brokered CDs offered by Fidelity, the presence of the FDIC insurance guarantee protects investors against the credit risk of the issuer, provided their total investment in that issuer remains below $250,000, per owner, per Account type. Any investment amount in excess of the $250,000 FDIC insurance protection is subject to credit risk and potential loss to the investor if the issuing bank or financial institution fails.
Inflation risk
Inflation risk is a particular concern for investors who want to live off their bond income, although it is a factor that everyone should consider. The risk is that inflation will increase, reducing the purchasing power of your income.
To combat this risk, consider U.S. Treasury Inflation-Protected Securities (TIPS). The TIPS principal is adjusted for any increase in the consumer price index, so that when the bond matures and the principal is repaid, that amount will be higher to match the inflation amount. (TIPS does not adjust at all if inflation falls over the life of the bond.) Because this inflation factor is part of the interest payment calculation, the interest payments for TIPS are variable even though the coupon is fixed. There are bond funds that invest exclusively in TIPS, but also some that use TIPS to offset inflation risk that can affect other securities in the portfolio.
Risk ring
A callable bond contains a provision that allows the issuer to call or repay the bond early. If interest rates are low enough, the bond issuer can save money by paying back its callable bonds and issuing new bonds at lower interest rates. If this happens, the bondholder's interest payments will stop and they will receive their principal early. If the bondholder then reinvests the principal in a bond with similar characteristics (such as creditworthiness), he will likely have to accept a lower interest payment (or coupon rate), one more in line with prevailing interest rates. Therefore, the investor's total return will be lower and the associated interest payment stream lower – a more serious risk for investors who rely on this income.
Before purchasing a convertible bond, investors should not only assess the bond's yield to maturity (YTM) but also consider the yield to be collected or worst case yield (YTW). Yield to worst calculates the worst yield based on the two possible outcomes: either the bond matures by the specified maturity date or is redeemed early.
Risk of prepayment
Some classes of individual bonds, including mortgage bonds, are subject to prepayment risk. Like call risk, prepayment risk is the risk that the issuer of a security will repay the principal before the bond's maturity date, thus changing the expected payment schedule for the bonds. This is especially common in the mortgage bond market, where a drop in mortgage rates can trigger a refinancing wave. When homeowners refinance their mortgages, the investor in the underlying pool of mortgage bonds receives the principal back earlier than expected and must reinvest at a lower prevailing interest rate.
Liquidity risk
Liquidity risk is the risk that you cannot quickly buy or sell investments at a price close to the true underlying value of the asset. When a bond is said to be liquid, there is generally an active market for investors buying and selling that type of bond. Government bonds and large issues from well-known companies are generally very liquid. But not all bonds are liquid; some trade very infrequently (municipal bonds, for example), which can be a problem if you try to sell before maturity. The fewer people are interested in buying the bond you want to sell, the more likely you are to have to sell at a lower price. price, which could potentially result in a loss on your investment. Liquidity risk may be greater for bonds with a lower credit rating (or that have recently been downgraded), or for bonds that were part of a smaller issue or sold by a rare issuer.
Balancing the risks of individual bonds versus bonds. bond funds and bond ETFs
Diversification
Because bond funds and bond ETFs are generally diversified across multiple securities, a single purchase with a limited investment amount can provide access to potentially hundreds of different issuers. This can help mitigate the downside impact of a credit event affecting one of the issuers.
Liquidity
The liquidity risk described above can be even greater for an individual bond. In certain cases, there may not be an active mutual market for a specific bond and the price discovery process may take several hours. In contrast, with a bond fund the investor has access to buy or sell at the end of the day, and with a bond ETF throughout the market day.
Return of principal
With individual bonds, as long as the issuer does not default, an investor is paid the face value of the bond when the bond matures. A bond fund or bond ETF, on the other hand, does not mature and its value will fluctuate. Although the price of a bond may fall, the investor has the option of waiting for the bond to mature or be redeemed.
Predictability of income
An individual bond's future cash flows from coupons and installment payments are contractually transparent and predictable - subject to insolvency as described above. Because a bond fund or bond ETF involves buying and selling the underlying investments, the total income they generate will fluctuate over time and is not known in advance. Fixed-term bond funds and ETFs attempt to bridge the gap between bond funds and individual bonds, offering more income predictability than traditional bond funds. Such funds "mature" on a specified date, at which time the proceeds are distributed to shareholders.
