Potential Pitfalls of Bond Investing
Bonds present investors with a number of potential benefits. In general, bonds have provided investors a better return with less volatility than stocks in the last 15 years. Economic events that tend to decrease stock prices have sometimes increased bond prices, and vice versa. Because of this relationship, adding bonds to a portfolio might provide significant diversification benefits. Bond investors normally receive income at fixed intervals, helping to meet certain cash-flow needs. However, as with any other investment, there are some risks that investors need to be aware of when adding bonds to an investment portfolio.
Interest-Rate Risk: Bonds and interest rates have an inverse relationship- bonds tend to rise in value when interest rates fall and fall in value when interest rates rise.
Inflation Risk: This is also known as purchasing-power risk. Inflation is a rise in the general level of prices for goods and services. If investments do not keep up with inflation an investor’s money will purchase less in the future than it did in the past. At their best, bonds have experienced very modest inflation-adjusted returns.
Credit Risk: This is the risk of a company that is selling bonds not being able to make timely payments of principal and interest. The value of a bond might also decrease because of financial difficulties or the declining creditworthiness of the issuer. It is important to keep in mind that corporate bonds aren’t guaranteed by the full faith and credit of the U.S. Government but are solely dependent on the company’s ability to repay the money that it has borrowed.
Liquidity Risk: Some investments might not be widely held by the public and can be difficult to sell (are not very liquid) if prices drop dramatically. Government bonds are usually very liquid investments; corporate bonds, however, might be difficult to sell quickly in certain situations.
Call/Reinvestment Risk: As interest rates fall, bonds with call provisions might be called (redeemed) by the issuer prior to maturity. While a premium is usually paid to the bond owner when the bond is called, this could leave the investor with the problem of reinvesting the principal at a lower interest rate.
Government bonds are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks and corporate bonds are not guaranteed. Stocks have been more volatile than the other asset classes.
Source: Stocks in this example are represented by the Standard & Poor’s 500, which is an unmanaged group of securities and considered to be representative of the stock market in general. Corporate bonds are represented by the Ibbotson Associates long-term corporate bond index, government bonds by the 20-year U.S. government bond, and inflation by the Consumer Price Index.
Disclosure: The posted information is for informational purposes only. This message does not constitute an offer to sell or a solicitation of an offer to buy any security. All opinions and estimates constitute Karp Capital's judgment as of the date of the report and are subject to change without notice. Accordingly, no representation or warranty, expressed or otherwise, is made to, and no reliance should be placed on, the fairness, accuracy, completeness or timeliness of the information contained herein. Securities offered through Infinity Securities (a registered broker-dealer, member FINRA, SIPC). Infinity Securities and Karp Capital Management are not affiliated companies.