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What are the risks associated with buying bonds?

and how do interest rates play into it?

May 14, 2012 by Indira from Springfield, MO in  |  Flag
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George Cones, JD Level 20

Many bonds have credit risk, like the bonds of corporations and some countries, like Greece. Almost all bonds have some interest rate risk. A useful took in evaluating interest rate risk is duration.

Since US Treasuries have a limited threat of default (or so we thought until last year), changes in interest rates are the biggest risk for US Government bonds. We will limit our discussion to Government bonds here.

How are bonds impacted by rising interest rates? Here is a simple example of why interest rates are important. Let's say an investor, we will call him Joe Smith, holds of a bond with a yield of 2.5%. Every year his $1,000 bond pays $25 in interest. If Joe holds this bond until it matures, we know he will make 2.5% per year on the bond.

But Joe needs to sell the bond. Since Joe bought the bond, interest rates have risen to 3.5% an otherwise identical bond. Joe has to sell his bond, but a prospective buyer can buy a similar bond that will pay him $35 per year in interest, instead of $25. Joe is a nice guy, but why a buyer purchase Joe’s bond that pays 1% less interest per year? He or she wouldn't. If Joe Smith wants to sell his 2.5% bond, he will have to discount the bond. That means he will have to reduce the price so the prospective buyer will get the 3.5% yield.

To help understand the risk in a bond or a portfolio of bonds (like a bond mutual fund) there is a helpful tool, duration. Duration is a common measure of interest rate risk in bonds. While it may be helpful to understand the theory of duration, it’s more important to understand how to use the duration information. The fact sheet or prospectuses for most bond mutual funds or ETFs will have the duration prominently listed.

With this duration number we can get some idea of how a portfolio may behave in different interest rate environments. A bond portfolio of long maturity US Treasury bonds may have a duration of 10, 11 or higher. The higher the number the more the risk (a 30 year zero coupon bond has a duration of 30). How does duration help us understand the sensitivity to interest rates?

There is a rule of thumb that helps us apply the concept of duration to understand rising interest rate's affect on a bond or portfolio of bonds. This rule of thumb provides that if interest rates go up or down by X% … one only needs to multiply the change in interest rates by the duration of the bond or portfolio of bonds to see how the market value of the portfolio will change.

For example if interest rates go up 1% and a bond or bond fund has a duration of 6, the value of the bond portfolio should go down by about 6% (1% multiplied by the duration of 6). So using our rule of thumb, a 1% increase in rates should cause the portfolios of US Treasury bonds with a duration of 10, 11 or higher to go down 10%, 11%, or more. For that 30 year zero coupon bond, the 1% interest rate rise could cause its market value to decline by 30%.

Bond mutual funds could be more risky than individual bonds, because of panic selling by some holders, which could lead to realized losses for all holders.

Comment   |  Flag   |  May 14, 2012 from Wilmington, DE

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Basically, bonds are interest rate sensitive investments. When interest rates move up, bond prices move down, and when interest rates move down, bond prices move up.

So in a rising interest rate environment, an investor could lose some or a significant part of their principal value.

Generally speaking the longer the maturity, the more highly sensitive the bond would be to interest rate changes. This is actually measured by a factor called “duration.” Duration is measure in years, so a bond having a duration of 2 years would be much less interest rate sensitive than a bond having a duration of 10 years.

To oversimplify this, if your bond has a 10 year duration, the price of the bond will move up or down 10% with a 1% change in market interest rates on similar bonds.

Does that make sense?

Comment   |  Flag   |  May 14, 2012 from Atlanta, GA

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Hi Indria,

I'm guessing you mean buying individual bonds as opposed to bond funds. If so the first risk is business risk of the company issuing the bond. If a company which issues a bond goes out of business the bond is worthless. The next risk is interest rate risk; what if you bought a ten year bond with a 3% coupon and in year four interest rates rise to 6%? You are now receiving much less interest than the market is currently paying. You could sell your initial bond, before the ten year term is up, but you will do so at a loss of principal because no one would pay par value in that scenario. So in that circumstance you'd have to sell the bond for less than you paid for it. If the situation was reversed you could actually sell your bond for a profit. Of course you would have to find a suitable replacement in a lower interest rate climate. Of course, if you held your bond to term and all was well with the company you would receive your yearly interest and the initial investment back after ten years. Another thing to remember about individual bonds is that most do not compound your interest. Usually the interest is sent to the bondholder or reinvested in a money market.

This leads me to the conclusion that most people are better off in bond funds because you have diversification, professional management, liquidity and the potential for a compounded return. The trade off is that we can't tell you what rate of return you will receive on a bond fund

Comment   |  Flag   |  May 14, 2012 from Cleveland, OH

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Hi Indria; The previous posts have done an excellent job of addressing credit risk, etc. of owning bonds; and the issue of individual bonds vs bond funds is also worth discussing since there are differing, though credible, views on the subject. Peter Lynch, the famed former Fidelity portfolio manager who was a Warren Buffet deciple, stated in his book, "One Up On Wall Street", that he could see no reason why anyone would ever own a bond fund... and you'll find professionals on each side of that debate.

To me, the answer is determined by (1) the purpose of the bond position(s) and (2) whether you're in a taxable or tax-deferred account.

Individual bonds do have some advantages:

• Individual bonds have a maturity date. Regardless of market swings and valuation changes, you know what your bonds will be worth on their respective maturity dates. So, if you’ve ‘laddered’ intermediate bonds, you know each will mature at face value – a strategy that can provide some comfort, since it can alleviate concern over valuation changes prior to maturity.

• Gains are realized only when taken, which is true for virtually all individual securities in taxable accounts. A mutual fund, however, is a ‘pooled money’ vehicle. When a fund takes a gain on a position, you pay your share of the freight on the fund portfolio’s entire gain for that position, even if you’d been a shareholder for only a day! The reason: you didn’t’ own that security; the fund did, and you are a shareholder in the fund, not the position.

• Direct ownership can lessen the impact of other investor trades. Think of it this way: When – I say `when’ because it’s bound to happen at some point – interest rates begin to rise, bond values will begin to decline. As those values – the fund prices investors see on their statements – begin to fall, you can expect many bond fund investors to begin selling their shares. When they do, fund managers are forced to sell-off bond positions to raise money in order to meet redemption requests from selling shareholders. That means they’d be selling when prices are heading lower… the very time they’d likely rather be buying! When fund managers sell-off with block trades, common sense tells you there has to be a ‘market impact’ cost attached. Owners of individual bonds aren’t forced to sell due to market swings when their purchases were made with a maturity date in mind because, as we said earlier, those bonds will mature at face on a date certain.

So, if individual bonds seem to offer some distinct advantages, do bond funds ever make sense in a portfolio?

My own view: While there is some obvious knowledge, skill, and talent attached to the selection of and management of domestic and foreign bonds, in terms of credit quality, etc., particularly where longer maturities are involved, most serious individual investors aren’t trying to beat the bond markets. Their larger concerns revolve around either dependable income, risk mitigation, or some combination of the two.

For the most part, particularly when it comes to what individual investors care about, bonds are what they are. A Treasury is a Treasury. For dependable income and risk mitigation, it’s hard to beat owning bonds directly.

But, for most people trying to achieve long-term goals, there is one alternative worth consideration in certain types of accounts.

While you might continue to use individual bonds in taxable accounts for reasons cited above, you may want to consider some sort of low-cost pooled vehicle in your tax-deferred accounts, i.e., 401(k)s, IRAs, etc. The reason is simple: It’s hard to rebalance your overall asset allocation with individual bonds. Who wants to sell-off individual bonds and rebalance into equity or vice-versa? It’s cumbersome and can be quite costly. There’s an old saying in the bond market: Buyers buy the market and sellers pay the freight.

There’s a better way: Use low-cost, no-load bond index funds or exchange-traded funds (ETFs) to fill-out your bond allocation and provide an easier vehicle for periodic rebalancing. Costs are low; you’re in a tax-deferred vehicle; and you’re managing more efficiently for risk mitigation.

So, for taxable accounts and income, I like individual bonds. For tax-deferred, long-term investing, using asset allocation for risk mitigation, I prefer low-cost index funds and ETFs rather than managed bond funds, which can add (in my view) needless expense in exchange for limited, if any, value.

It's my view; but, I'm sure you'll hear other well-informed opinions, as well.

Comment   |  Flag   |  May 14, 2012 from Moorpark, CA

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Apart from credit risk and interest rate risk mentioned above, bonds are currently so expensive (meaning yields are so low) that you have to add purchasing power risk to the list of bond risks. That is, interest rates on bonds are now below the inflation rate.

How expensive are bonds? According to the Bank of England, bonds have never been more expensive than right now since at least 1703 (when that institution began keeping records).

Comment   |  Flag   |  May 14, 2012 from Bryn Mawr, PA

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Good advice from the other advisors here. I would add one point to discussion about bonds vs. bond funds: for individual investors, bond funds or ETFs offer the benefits of diversification, high liquidity and high transparency compared to individual bonds.

The bond market remains a swamp for individual investors, with absurdly high markups charged by most full-service and discount brokers alike. There have been attempts to level the playing field by moving bond trading to organized exchanges or creating transparent, multi-broker platforms. But none of these efforts have really taken off in a meaningful way.

Anyone who wishes to invest in fixed income would be well advised to use ETFs or low-cost, well-defined, transparent bond funds.

1 Comment   |  Flag   |  May 14, 2012 from San Francisco, CA
George Cones, JD

James, we would like to add that while index bond funds and ETFs should be part of a diversified bond portfolio, there are a few bond funds that have a great long-term track record, like Loomis Sayles Strategic Income and PIMCO Total Return Fund. Dan Fuss and Bill Gross have 30+ year track records of adding value. There are some other actively managed bond funds that may add a unique element of diversification. An advisor (who is not paid on commission), can use, certificates of deposit, government bonds and agencies to outperform money market funds, or build a cash ladder where cash flow needs are well established. We employ this strategy in conservative portfolios to add 10, 20, or 30 basis points.

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Flag |  May 15, 2012 near Wilmington, DE

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