Introduction
Bonds are often used to reduce portfolio volatility and generate income, but they are not risk-free investments. A bond can lose market value, an issuer can fail to make promised payments, and inflation can reduce the real value of future cash flows.
The level and type of risk vary widely. A short-term U.S. Treasury security has a very different risk profile from a long-term bond issued by a heavily indebted company. Understanding those differences is essential when comparing bonds.
This guide covers the main risks bond investors encounter and explains why higher yields often come with greater uncertainty.
Interest-rate risk
Interest-rate risk is the possibility that changing market rates will reduce the value of an existing bond. For conventional fixed-rate bonds, prices and market yields generally move in opposite directions.
If market rates rise, newly issued bonds can offer more attractive coupons or yields. Existing bonds with lower fixed payments may therefore fall in price. If market rates decline, existing higher-paying bonds may rise in value.
The effect is generally greater for bonds with longer maturities and greater interest-rate sensitivity. Investors who need to sell before maturity can therefore experience losses even if the issuer continues making every scheduled payment.
Credit and default risk
Credit risk is the risk that an issuer’s financial condition deteriorates or that the issuer fails to make required payments. An actual failure to meet debt obligations is generally referred to as a default.
Credit concerns can affect a bond before any default occurs. If investors become less confident in an issuer, they may demand a higher yield, which can push the bond’s market price lower.
Credit risk is particularly important for corporate bonds, although governments and other issuers can also face credit problems.
Inflation risk
Inflation risk is the possibility that rising prices reduce the purchasing power of a bond’s future payments. This matters especially for fixed-rate bonds because their nominal coupon and principal payments do not automatically rise with the cost of living.
For example, receiving $1,000 several years from now may buy fewer goods and services than $1,000 buys today if prices increase in the meantime. A bond can therefore deliver its promised nominal payments while producing a weaker real, inflation-adjusted return.
Inflation-protected securities are designed to address some of this risk, but they have their own pricing and interest-rate characteristics.
Liquidity risk
Liquidity risk is the possibility that an investor cannot sell a bond quickly at a price close to its perceived fair value. Some government securities trade in deep, active markets, while individual corporate or municipal bonds may trade much less frequently.
When liquidity is poor, the gap between buying and selling prices can widen. An investor who needs to sell quickly may have to accept a lower price, particularly during periods of market stress.
Reinvestment and call risk
Reinvestment risk
Coupon payments or returned principal may need to be reinvested at lower interest rates than the original bond offered. This can reduce the return an investor actually earns over time.
Call risk
Some bonds allow the issuer to repay the debt before its scheduled maturity. An issuer may be more likely to call a bond after rates fall, leaving the investor to reinvest the proceeds at lower prevailing yields.
Currency risk
Investors who buy bonds denominated in a foreign currency are exposed to exchange-rate movements. Even if the bond performs well in its local currency, a decline in that currency against the U.S. dollar can reduce the return measured in dollars.
Currency movements can also increase returns, but they add another source of uncertainty that is separate from the issuer’s credit quality and the bond’s interest-rate sensitivity.
Maturity and duration matter
Maturity tells investors when a bond is scheduled to repay principal, but maturity alone does not fully describe interest-rate sensitivity. Duration is a measure used to estimate how sensitive a bond’s price is to changes in yields.
In general, bonds with longer duration experience larger price changes for a given change in interest rates than bonds with shorter duration. Coupon size, maturity, and yield all influence duration.
This is why two bonds issued by the same borrower can react differently to the same move in market rates.
How risks differ across bonds
| Bond characteristic | Risk that may be more important |
|---|---|
| Long maturity or duration | Interest-rate risk |
| Lower credit quality | Credit and default risk |
| Fixed payments over many years | Inflation risk |
| Thinly traded security | Liquidity risk |
| Callable bond | Call and reinvestment risk |
| Foreign-currency bond | Currency risk |
These risks can overlap. A long-term lower-rated corporate bond, for example, can simultaneously carry substantial interest-rate, credit, inflation, and liquidity risk.
Does holding a bond to maturity remove the risk?
Holding an individual bond to maturity can reduce the importance of interim market-price fluctuations if the investor does not need to sell. However, it does not eliminate credit risk, inflation risk, reinvestment risk, or the opportunity cost of being locked into a lower rate.
It is also important to distinguish individual bonds from bond funds. Bond funds generally do not mature in the same way as a single bond because the portfolio continually buys and sells securities. Their share prices can therefore remain exposed to changing interest rates and market conditions.
Balancing yield and risk
Higher-yielding bonds can offer greater income potential, but the additional yield usually exists for a reason. Investors may be accepting weaker credit quality, longer duration, lower liquidity, call features, currency exposure, or some combination of these risks.
Rather than evaluating yield in isolation, investors can compare the source of the yield and the risks required to earn it. This applies to both government bonds and corporate debt.
Key takeaways
- Bonds can lose value even when issuers continue making scheduled payments.
- Rising market rates generally reduce the prices of existing fixed-rate bonds.
- Credit risk includes both actual default and deterioration in an issuer’s perceived ability to repay.
- Inflation can reduce the real purchasing power of fixed bond payments.
- Liquidity, reinvestment, call, and currency risks can also affect returns.
- Longer duration generally means greater sensitivity to changes in interest rates.
- A higher yield often signals that investors are being compensated for taking additional risk.