Are Bonds as Safe as they Seem?

BondsWhen talking about safe investments, bonds are typically referred to as the safest asset class.  However, how safe are bonds?  Bonds carry many of the same risks as stocks, so it is important to understand how they work.  Here is what you need to know about the safety of bonds.

How Bonds Work

A bond is essentially an IOU or debt instrument issued by someone, usually a company or government entity.  Think of it as the reverse of a loan – you are lending someone money, and they pay you interest for doing it.  When you buy a bond, you are lending money to the company or government that issued the bond.

All bonds have the following features:

–       Maturity: How long the bond is held until it is repaid

–       Coupon: The interest rate paid on the bond

–       Price: The face value of the bond

–       Frequency: The frequency that you get paid interest (monthly, quarterly, annually)

–       Callable: Whether the bond can be called and repaid early

With a bond, if you buy it when they are issued and hold it to maturity, you will buy it at the face value, earn interest based on the coupon, and then get your full face value back at maturity.

However, most people do not hold bonds until maturity or buy them when they are issued.  Instead, they buy them when they have money or when they think market conditions warrant it.  As such, bonds trade like a stock during the period between issue and maturity.

However, because bonds have many fixed features (maturity and coupon), they trade in a predictable way.  When interest rates are lower than the coupon rate, and the safety of the bond is high, the price will rise.  When market interest rates are higher than the bond, it’s not worth owning the bond so the bond price goes down.

The Biggest Risks of Bonds

The two biggest risks of bonds are the risk that the issuer will go bankrupt and not be able to repay the debt, and the interest rates in the market will change.

For the issuer, since this is a debt instrument, there is always the worry that the bond won’t be repaid.  Think of the mortgage crisis – lenders thought they were secure in their loans, but a lot of borrowers couldn’t afford it and stopped paying, and several banks went out of business.  The same is true with bonds issued by companies or even governments.  If you owned bonds issued by the city of Stockton in California, those bonds may be worthless after it exits bankruptcy.

The other risk of bonds is that the interest rates may change, making current bonds worth less in price than what they were paid for.  For example, if you could only earn 1% in a savings account, but bonds are paying 3%, the bond looks good.  However, if savings account interest rates rise to 5%, why would you want to own a bond?  That makes people sell bonds, and the price goes down.

Are Bonds The Right Investment Now?

So, are bonds a good investment right now?  Yes and no.

Bonds can be a good investment right now if you value safety over anything else.  You can invest in a US Government Bond, which is considered very safe because, in essence, the entire government would have to collapse to not pay which is highly unlikely.  However, these bonds pay almost zero interest.  So, in exchange for safety of not losing principal, you don’t gain anything.

They may not be a good investment because interest rates are so low right now, and bond prices are extremely high as a result.  As such, as interest rates rise in the future (which they will, you just don’t know when) bond prices will fall, and if you sell before maturity, you could take a loss.

Readers: Do you buy bonds? Through ETFs or directly through your discount broker?

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