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Are Bonds as Safe as they Seem?

BondsWhen talking about safe investments, bonds are typically referred to as the safest asset class.  However, how safe are bonds?  Bonds carry many of the same risks as stocks, so it is important to understand how they work.  Here is what you need to know about the safety of bonds.

How Bonds Work

A bond is essentially an IOU or debt instrument issued by someone, usually a company or government entity.  Think of it as the reverse of a loan – you are lending someone money, and they pay you interest for doing it.  When you buy a bond, you are lending money to the company or government that issued the bond.

All bonds have the following features:

–       Maturity: How long the bond is held until it is repaid

–       Coupon: The interest rate paid on the bond

–       Price: The face value of the bond

–       Frequency: The frequency that you get paid interest (monthly, quarterly, annually)

–       Callable: Whether the bond can be called and repaid early

With a bond, if you buy it when they are issued and hold it to maturity, you will buy it at the face value, earn interest based on the coupon, and then get your full face value back at maturity.

However, most people do not hold bonds until maturity or buy them when they are issued.  Instead, they buy them when they have money or when they think market conditions warrant it.  As such, bonds trade like a stock during the period between issue and maturity.

However, because bonds have many fixed features (maturity and coupon), they trade in a predictable way.  When interest rates are lower than the coupon rate, and the safety of the bond is high, the price will rise.  When market interest rates are higher than the bond, it’s not worth owning the bond so the bond price goes down.

The Biggest Risks of Bonds

The two biggest risks of bonds are the risk that the issuer will go bankrupt and not be able to repay the debt, and the interest rates in the market will change.

For the issuer, since this is a debt instrument, there is always the worry that the bond won’t be repaid.  Think of the mortgage crisis – lenders thought they were secure in their loans, but a lot of borrowers couldn’t afford it and stopped paying, and several banks went out of business.  The same is true with bonds issued by companies or even governments.  If you owned bonds issued by the city of Stockton in California, those bonds may be worthless after it exits bankruptcy.

The other risk of bonds is that the interest rates may change, making current bonds worth less in price than what they were paid for.  For example, if you could only earn 1% in a savings account, but bonds are paying 3%, the bond looks good.  However, if savings account interest rates rise to 5%, why would you want to own a bond?  That makes people sell bonds, and the price goes down.

Are Bonds The Right Investment Now?

So, are bonds a good investment right now?  Yes and no.

Bonds can be a good investment right now if you value safety over anything else.  You can invest in a US Government Bond, which is considered very safe because, in essence, the entire government would have to collapse to not pay which is highly unlikely.  However, these bonds pay almost zero interest.  So, in exchange for safety of not losing principal, you don’t gain anything.

They may not be a good investment because interest rates are so low right now, and bond prices are extremely high as a result.  As such, as interest rates rise in the future (which they will, you just don’t know when) bond prices will fall, and if you sell before maturity, you could take a loss.

Readers: Do you buy bonds? Through ETFs or directly through your discount broker?

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12 Responses to "Are Bonds as Safe as they Seem?"

  1. Only invest in bond ETFs. That’s it, and not very many. They barely keep up with inflation. :)

    Mark

  2. Dsenns says:

    Personally when I think of safety, bonds these days just don’t fit that bill. unless your in the Primo A+++ companies or countries, If your in those A+++ you won’t be making any money anyway. So all my “fixed income” is in laddered GIC’s. I hold them at my local credit union for between 3% and 3.4% which easy beats what A+++ bonds are paying, beats inflation, and in Manitoba (where i live) they are 100% backed by the government.

    • The Passive Income Earner says:

      @Dsenns
      Well done in your ladder GICs.

      The yield is definitely not there but bonds continue to be a big topic when it comes to balancing investment. Over time, it might be better.

  3. I’m not a fan of bonds because of the current low interest rates being offered. For one thing it seems you are losing purchasing power because inflation is running higher than the bond interest rates. Also once interest rates start to climb (don’t know when that will be but assuming they have no where to go but up eventually) all current bonds will drop in value quickly.

    With that being said though, I do have a portion of my money invested in a high income bond mutual fund. The returns have been gangbusters and the yield is over 8%. Junk bonds are certainly more risky but that is why I leave it to the experts to buy the bonds and I just invest in the fund.

  4. I have been meaning to at least start to look into bonds. I invest in them thru my 401k, but not on my own. The interest rates are just so low, it almost seems as if it isn’t worth the effort.

    One alternative that I’ve read about recently is peer-to-peer lending, where essentially you act as a bank and lend to another person, who is in need of a loan. The risk is higher, but so is the interest!

  5. I’ve been trying to stay away from bonds in my mutual fund investments, namely the 401k. I’m only carrying a 5% allocation to bonds there because bond mutual funds will get hit hard if/when rates rise. Owners of individual bonds will do alright, although keeping up with inflation will be an issue. It’s just too hard to purchase individual bonds because the capital requirements are usually too high and that kills your diversification risk.

  6. I’m holding off on bonds until the interest rise. When the rate improve, I’ll reallocate.

    • The Passive Income Earner says:

      @Retire By 40
      For me, it would simply be a way to hold cash (safely) and balance between cash and stock when markets drop.

  7. farcodev says:

    I personnally don’t like bonds. I only use dividend stocks for growth and bullion for wealth protection.

  8. gibor says:

    In my RRSP I hold only CBO (short term cor bonds),CHB (junk bonds ETF), TDB909 and Real-return bonds… I don’t really understnad how bonds work, so stick to ETFs.
    I also hold some TD bonds in my kids RRSP

  9. Tamara says:

    A friend suggested that I invest in bonds several years ago. I have not really thought about it because I cannot understand the entire concept of stock bonds.

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