Fixed-income securities have been a part of investors’ portfolios for decades, helping retirees and savers alike generate income to help meet their financial goals. Fixed-income investing has generally been viewed as less risky than investing in the stock market because it involves less volatility. But less risk does not mean risk-free.
Let’s take a look at some of the biggest risks around fixed-income securities.
1. Credit risk
As a bond investor, your return will come from the payment of coupons and principal at the specified times, the reinvestment of those coupons, and any profit or loss if you sell the bond before its maturity date.
Credit risk is the risk of a loss due to the bond issuer not making the required principal or interest payments on time or at all. When an issuer misses a payment, it is considered to be in default. Financial success, or even solvency, isn’t guaranteed for businesses or governments and sometimes there isn’t enough cash to meet their debt obligations. Typically, bondholders are not completely wiped out in the event of a default, but the ultimate impact depends on investors’ recovery rate.
Credit risk is a major risk for bond investors, but there are additional credit-related risks that investors should be aware of too.
2. Spread risk
Bonds issued by corporations or other entities that carry credit risk typically trade at a yield premium to bonds that are considered to be free from the risk of default, such as U.S. Treasury bonds. This yield premium, or spread, can widen due to a decline in the issuer’s creditworthiness or a decrease in the bond’s liquidity, causing its price to fall.
3. Downgrade risk
This refers to the risk that a bond issuer’s creditworthiness declines, causing its yields to move higher and bond prices to fall. It is called downgrade risk because deteriorating creditworthiness would likely cause the major rating agencies, such as Moody’s, Standard & Poor’s and Fitch, to lower their rating, or downgrade the bond.
4. Liquidity risk
This risk occurs when the price where you can actually buy or sell a bond is different from the price indicated in the market. Investors may not be able to purchase or sell bonds in their desired amount, so bonds with liquidity risk will usually trade at higher yields than otherwise comparable bonds.
Issuers with a large amount of outstanding debt typically have lower liquidity risk and issuers with poor credit quality often come with higher liquidity risk. Liquidity risk can also increase during times of crisis or a market panic.
5. Inflation risk
Fixed-income investors pay special attention to inflation because it can eat into the return they ultimately earn. A bond yielding 2 percent will leave investors worse off if inflation is running at 3 percent or higher. Inflation expectations generally get baked into interest rate levels, but perceptions can change quickly and send rates higher or lower.
Falling interest rates have provided a tailwind to bond prices for decades. In 1981, investors in a 10-year U.S. Treasury bond received a yield of almost 16 percent. Forty years later, that yield has fallen to less than 1.5 percent. But some are warning that the golden days for bond investors are behind us.
6. Interest rate risk
Another major risk associated with fixed-income investing is the risk of a change in interest rates. Bond investors are impacted by fluctuations in rates because it changes the rate that coupon payments can be reinvested at and also changes the market price of the bond if they’d like to sell before the bond’s maturity date.
Bond prices fall as interest rates rise, but interest rates have been on a steady decline for decades, which can make some investors forget or ignore risks tied to changing interest rates.
7. Reinvestment risk
This risk refers to the possibility that you won’t be able to reinvest a bond’s coupon payments at a rate similar to the current return. This risk can be mitigated somewhat because falling interest rates will increase the market price of the bond. Reinvestment risk is highest with high coupon rates and long reinvestment periods.
CDs also come with reinvestment risk because when a CD matures, you may not be able to invest the money at the same rate. At the same time, if rates increase after you’ve purchased the CD, you won’t be able to take advantage of the higher return due to the fact that most CDs require you to leave your money alone until the term ends, or get hit with an early withdrawal penalty.
8. Price risk
Price risk relates to the impact changing interest rates have on the market price of the bond. Bondholders with shorter time horizons, such as short-term traders, have the greatest exposure to price risk because they might sell a bond before they even receive a coupon payment.
Fixed-income investing may come with less volatility than investing in the stock market, but that doesn’t mean it comes with guaranteed returns or no risk.
“Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future,” legendary investor Warren Buffett wrote in his annual letter to shareholders earlier this year. “Bonds are not the place to be these days,” he said.
To be sure, fixed-income assets can provide some diversification benefits to investors. U.S. Treasury bonds are often considered defensive by investors, meaning their prices rise during times of market stress when stocks may be declining substantially.
Make sure you understand the credit quality of the bonds or bond mutual funds you’re investing in and think through how changes in interest rates could impact your portfolio.