Like all investments, investing in bonds carries a degree of risk. In fact, there some risks that relate specifically to bonds:
- Credit risk
- Interest rate risk
- Income risk
- Call risk
Credit risk refers to the chance that the bond issuer will default, and you’ll lose your investment principal. This is exactly why bonds are rated, just like we are when we apply for credit. As a potential investor, it’s a good idea to compare the risk and the return, or yield, you’ll get from different grades of bonds. For example, if you’ll earn almost as much interest on a high-grade tax-exempt municipal bond as you will with a lower-grade taxable corporate bond, it makes more sense to go with the muni. Buying riskier, lower-grade bonds is only ever worthwhile if your potential returns are big enough to justify taking that credit risk.
Interest rate risk comes into play when you don’t plan on holding bonds to maturity, expecting to sell them before they come due. Changing interest rates impact bond prices – and we haven’t seen too much fluctuation here for a while, but the tide could be turning. Essentially, the risk here is that you’ll either be stuck with a long-term bond that pays less than the current interest rate, so you’ll miss out on the new higher rate, or you’ll have to sell the bond at a discount, and you’ll have less to reinvest in new higher-interest bonds.
Income risk is a double-sided risk. Side one is that if you sell, you won’t get the full value (or par) of the bond, and side two is that inflation will surpass the rate of income you’re getting from the bond (also known as inflation risk). One way to manage income risk is to stagger or ladder your bonds so that you can pick up the higher interest rates along the way as older bonds mature.
Call risk means the bond issuer can buy you out of your investment before the maturity date, whether you want to sell or not. This can happen when rates drop – exactly the time you’d want to hold on to these bonds – and the issuer wants to call in high interest bonds so they can issue new ones at the now lower rate.