What are the key risks of investing in bonds?
Bonds are less risky than shares, but they do still contain risk. Below we outline some of the key ones:
The price of bonds can move around depending on the level of interest rates. For example, say that you bought the Victorian Government Green bond in 2016 which pays an interest rate of 1.75% p.a. The cash rate at the time the bonds were issued was 1.75%, meaning you were getting paid the cash rate at the time of purchase.
Fast forward to 2020 and the cash rate is 3.50%, now you own a bond that is paying you 1.75% less than the cash rate. Investors would rather buy a bond that is paying them the 3.5% current cash rate than one paying them 1.75%. Because of this, the price of your 1.75% bond has gone down. At the end of the 5 years, you will still get your $1,000 back, but in the intervening years the price of your bond will move around and you will have missed out on the additional 1.75% return that other investors were able to earn during that period.
Because bonds are generally lower risk, they also offer lower returns. This introduces the possibility that your return may not keep up with inflation. For example, the interest payment on the Victorian Government Bond of 1.75% is below the average inflation rate of 2.50%, which means that at the end of the 5 year term the purchasing power of your investment will have fallen, introducing the risk that during the term of your investment you may have lost money in real (i.e. inflation-adjusted) terms.
In buying a bond, you are essentially lending money, leaving you exposed to the credit risk of the borrower. A bond is a legally binding obligation to repay the debt, however a company (or Government) in bankruptcy may not have the money to repay. As such, you should be happy with the risk of the company you are buying a bond from.
One of the key ways that people measure credit risk is via a credit rating, you can read more about them here. The ratings go from AAA (lowest risk of default) to C (highest risk of default). The higher the risk of default, the higher the interest rate that the bond should pay. To minimise risk, it is generally best not to invest below a BBB- rating.
The Victorian Government is rated AAA, meaning that there is a low risk of default, which is why the interest rate is so low at 1.75%. It is worth noting that credit ratings can change, which may impact the price of your bond. If you invest in a AAA rated bond, which is subsequently downgraded (e.g. to AA), then the price of the bond is likely to fall.
Bonds are part of the financial markets and are subject to falls in prices when the bond market declines. For example, when interest rates begin increasing, the bond market as a whole usually falls due to the inverse relationship between bonds and interest rates.
Bonds are also impacted by the share market. A study found that in periods of market volatility, the correlation between the bond and share market can get up to 0.50. This means that if the share market drops by 1%, the bond market could drop by 0.50%.
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