Are Bonds Risk Free?
Date Added: November 3rd,
2003
By Chris Stallman
| E-mail
I've been thinking
about investing bonds for some time now and I keep reading that
they are "low-risk." Shouldn't they be considered
no-risk? I'm referring to government bonds but I think it should
apply to all bonds. Am I right? -Ajih, (Tampa, FL)
Thanks for the question
and to answer it, bonds are
low-risk. They're considered less risky and volatile than common
stocks are. However, it's important to understand that there
are some small risks involved with investing in bonds. These can
be broken down into two categories:
Risk #1: Defaulting
If you buy corporate
bonds, you are essentially buying a claim to their assets. Just
as with individuals, corporations take on debt in hopes to grow.
Sometimes they take on too much or their operations start to perform
poorly and they are unable to repay their debts. This is just like
someone taking on too much credit card debt and then having to file
for bankruptcy. At times, companies will fire for bankruptcy and
won't be able to repay the principal on their debt. This means
that the investor can theoretically lose their entire investment,
although this is not a particularly common occurrence.
The CPI
does not evaluate the quality of products and does not measure the
constantly changing taste of Americans. However, this number gives
us an easy way to determine if the cost of living in the US is going
up or down. If it's going up, it could mean inflation is on
the rise. But we'll cover that in another article.
Risk #2: Changing Interest
Rates
When you invest
in a bond, you can sell it on the market at any time. And like a
stock, each bond has a certain price that the market assigns to
it. Because you might end up selling it on the open market, you
have to understand that people not only care what interest rate
the bond pays but also the interest rate that the market currently
has. For example, if you own a bond paying 6% interest and you
want to sell it one year later on the open market when the interest
rate is 8%, you're going to get a lower price than what
you paid. After all, why would anyone buy your 6% bond if they
could get a new 8% bond? The only way they will do it is by
buying your bond at a discount.
The longer you hold your bond, the less likely you
are to lose money on it. And bonds are typically a long-term investment,
so this shouldn't really be a big concern for you.
Tips to Avoid Risk
If you invest
in corporate bonds, make sure you read up on what their current
bond rating is. A bond rating is basically a letter grade assigned
to each bond to tell investors how risky it is. If you want to avoid
risk, stay away from "junk" bonds.
Also, to help avoid the chance of losing money on a
bond because of changing interest rates, don't buy bonds when
interest rates are low. The higher the interest rate rises, the
lower the price of your bond will fall.
In general, stick with bonds for the long-term and
try to invest in them when you think the interest rate is reasonable.
This will help you maximize your returns and minimize your risk.
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