Are Bonds Really Risk-Free Investments?
Many people assume that diversifying their portfolio skewed towards bonds will protect their investments from any risk. While bonds are a great way to reduce risk, nothing can fully eliminate risk from a portfolio; even a portfolio that consists entirely of bonds is subject to risk just like stocks, but the exposure and variety of risks differs based on the nature of fixed income securities.
While these may sound scary, they are very simple to understand and diversify away. The only bond close to risk-free is a U.S. Treasury bill, those these risks below are meant to highlight the risks associated with corporate and municipal bonds.
It is important to diversify with bonds, but like all investments it is important to be informed of all that could potentially harm your retirement plans.
This is the risk that the proceeds from the payment of principal and interest, which have to be reinvested at a lower rate than the original investment. Call features affect an investor's reinvestment risk because corporations typically call their bonds in a declining interest rate environment.
This is the risk that occurs when a bond issuer will redeem their bonds before they mature. Call provisions are exercised when issuers are able to refinance their debt at a lower interest rate than the current coupon rate. This is an advantage for the issuer but a disadvantage for the bond holder (you).
A maturity risk premium is the amount of extra return you'll see on your investment by purchasing a bond with a longer maturity date. Maturity risk premiums are designed to compensate investors for taking on the risk of holding bonds over a lengthy period of time. As a general rule of thumb, the longer the time until the maturity of a bond, the more volatile the price will be. This is generally due to the time value of money (a dollar today is worth more than a dollar in the future), since the value of future coupon payments is increasingly impacted by the length of time that must pass before the coupons are received.
Interest Rate Risk
Interest rate risk is the risk that changes in interest rates (in the U.S. or other world markets) may reduce (or increase) the market value of a bond you hold. Interest rate risk—also referred to as market risk—increases the longer you hold a bond.
A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. Credit rating is a highly concentrated industry, with the "Big Three" credit rating agencies controlling approximately 95% of the ratings business.Moody's Investors Service and Standard & Poor's (S&P) together control 80% of the global market, and Fitch Ratings controls a further 15%. The largest two have different bond rating systems (which will be discussed at a later date), but the U.S. government bonds are considered the highest grade bonds possible since the risk of default is so low.