Bonds and Treasuries

What are risks of bonds?

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September 15, 2007 11:11AM

Although bonds are usually considered safer than stocks, they still have many risks. There are four main components to a bond. It is important to understand this so that the rest of the answer makes sense. First, there is the value... the face value of the bond. Then there is the coupon interest rate... the percentage interest you will earn on the face value per year. Then there is the maturity date... the date that the borrower must pay you back... and last, there is the borrower... the organization that is borrowing the money from you. There are other components like call features which I will touch on later. So the first risk I'll mention is issuer risk. When you buy a bond, you become a creditor to the organization that is issuing the bond. In other words, you are lending money to that organization. So if I buy a $10,000 bond for Ford Motor, I am essentially lending Ford Motor my money. Therefore, if Ford Motor goes bankrupt, I may not see my money again. It is for this reason, that their are financial firms that rate the quality of bonds based upon the financial strengh of the borrowing organization. Anything from Aaa to Bbb rating is considered investment grade... which means you really shouldn't worry about the company going bankrupt. Anything less than that (C and below) is considered "junk bonds". Investing in junk bonds can actually be very lucrative if you know what you are doing. However, you also risk a greater chance of losing it all since the company you are lending to is not financially sound. Another risk is interest rate risk. The price of bonds move up and down inversely with interest rates. When interest rates go up, bond prices go down and visa versa. Therefore, if I buy a bond for $10,000 and the next day, interest rates drop, the value of my bond (if I wanted to sell it) might be only $9,950. If you intend to hold the bond until maturity (when the borrowing organization must pay you back) and the borrowing organization is strong, such risk is not worth worrying about since at maturity you will get the full $10,000. Bonds sometimes have call features that might affect the bond. This could open you up to something called reinvestment risk. A call feature on a bond allows a company to repay your bond before the stated maturity. They will do this usually when interest rates have fallen lower than the interest that they are paying you to borrow your money. Generally, they will repay your bond and go out a find new lenders to borrow from at a lower interest rate. This is how they save money. It is a risk to you because you now have to reinvest your cash into a new bond... but since interest rates are lower than the rate you were earning with the old bond, you will likely earn less money if you were to invest in another bond of similar quality and size. Some other good things to know... Unlike stocks, bond generally do not trade with a commission, or a fee to process the transaction. Rather they have what is called a markup or markdown. A markup is the buying price. A markdown is the selling price which is lower than the markup. The difference between the two is called the spread, which is the amount of profit that the broekage firm makes in buying bonds from one client and selling them to another. In case, you are wondering... it is totally legal (as long as the spread isn't too high), so you better get used to it if you wish to invest in bonds. Also, another good thing to understand is that a $10,000 bond can technically buy or sell at prices that are higher or lower than its face value. As an example, Assume that current interest rates are at 5% and I own a 7% bond that I bought years ago with a face value of $10,000. If I chose to sell the bond to someone else, I will likely get a price much higher than $10,000 (unless there is a call feature). Why? Because in order to make my 7% bond into a 5%, the buyer needs to pay me $14,000 for the bond. How does this math work? A 7% bond with a face value of $10,000 earns $700 per year. Howewer, if current interest rates are at 5%, I will need to receive $14,000 for the bond so that the $700 per year that the new owner will earn represents only 5% of the amount that s/he paid, $14,000 (Remember, the interest that the new owner will receive is still based on the face value of the bond and not on the $14,000 price s/he paid for it). This illustration further shows why bonds values go up when interest rates go down an visa versa. This also highlights how some professionals will buy bonds when they expect interest rates to drop soon. The rates drop and the price goes up... and they sell for a profit. I'm sure true investment professional might be able to indentify more risks. But these are the main ones.