Traditionally, stocks are considered higher risk and bonds more safe. You might have built a portfolio based around stocks and bonds, with the percentage of bonds a sign of how much stability you want in your investments. Bonds certainly aren’t prone to dramatic crashes like individual stocks may be.
However, some have credited the Silicon Valley Bank crash to an over-reliance on bonds in its investments. As interest rates go up, bonds are said to become less valuable. Does that mean bonds are no longer stable in a high interest rate environment? If bonds are no longer a safe investment, where should you keep your money?
How Bonds Work
A bond is, in essence, a loan that you make to another party, whether that’s the federal government, a local government, or a corporation. You purchase the bond, usually symbolizing $1000 worth of that entity’s debt. Each year you hold it, you earn an amount of money called its coupon yield, which is basically the interest the entity pays on its loan. And on the maturity date, you receive $1000. Your actual profit comes both from the yield and from any difference between what you paid for it and the $1000 you receive at the end.
You see, in some markets you might only pay $900 for a $1000 bond. Thus you would earn the interest on the bond and also $100 in profit between what you paid and what you got at the end.
The risk here is generally low. You know at the time of purchase what you will earn—the coupon yield plus $1000 at maturity. There is always some risk of default, in which the entity you bought the bond from can’t repay the debt. But that depends on the type of bond you purchase. If it’s a corporate bond, the default risk depends on the strength of the corporation that issued it. Bonds issued by the federal government are very safe, as it reliably pays its debts.
The Secondary Market
If you buy a bond at a good price and hold it to maturity, you can expect to receive a predictable profit. That’s why people think of bonds as very low-risk products. However, bonds are constantly resold on the secondary market. If you bought a bond at $900 and the market price rises to $950, you might start thinking it makes sense to sell it now and reinvest the profit. However, bond prices can also fall. If you’re holding a bond and its market price drops, you can’t recoup your money except by waiting for the maturity date. That can be a problem if you need money now.
Bond prices are vulnerable to two main pressures: inflation and interest rates. If inflation is high, people may worry the $1000 they receive at maturity won’t be worth as much by then, and that drives down the market price of bonds. Meanwhile, when interest rates are high, bond yields also go up. That means a bond you bought in 2020, when the federal interest rate was 0%, will likely have a lower yield than a bond issued today, when interest rates are higher.
So what if you want to sell a bond you bought then and buy a new one with a better yield? You’ll be dealing with all the other people who want to do the same thing. Who wants a 2020 bond when they can get a 2023 bond at better rates? The result ends up being a drop in the market prices of older bonds.
Bonds suffer from two kinds of risk: credit risk and interest rate risk. Credit risk is the risk that the bond issuer will default on their debt and fail to pay you at maturity. This can be alleviated by buying bonds issued by trustworthy entities. The US Treasury issues bonds that are considered completely safe from default—historically, it has always paid bonds and is expected to continue to do so.
Interest rate risk is the risk that your bond will drop in market value before maturity. If you intend to hold it that entire time, that risk isn’t important to you. You weren’t going to sell it anyway. It’s similar to being upside-down on your mortgage. If you don’t want to move, it doesn’t matter much. All you lose is the opportunity cost. You could use that same money to buy a better bond with better terms if you had the cash today. But you will still receive everything you counted on when you purchased the bond: the coupon yield (that is, the interest) and the $1000 face value on maturity.
If you do intend to resell your bonds, be aware that increased interest rates will result in a lower market value of your older bonds as buyers prefer newer bonds. This effect is larger on longer-term bonds.
Bond Risk Strategy
How do you prevent losing money on bonds? First, be aware that bonds are a long-term strategy. While you can sell them, that could lose you money in some markets. So invest in bonds with money you do not expect to need immediately. That way, you can sell if the secondary market for them is good, but you can also hold them until maturity if it isn’t.
Second, always keep your portfolio diverse. While conventional wisdom is that stocks are high risk and bonds are lower risk, having a portfolio of purely bonds would not be entirely safe either. You need to divide your investments among many types of products, including products which react to market conditions differently. For instance, the financial sector sometimes does well when interest rates are high. You’ll also want a variety of short and long-term investments. Since short-term bonds are affected less by increased interest rates, they are a useful addition to the bond portion of your portfolio.
Don’t Invest Alone
Making a portfolio diverse enough to stay secure through any market isn’t a job you can easily do on a weekend. An expert can help you find a mix of products which can see you through inflation, high interest rates, market contractions, and more. You’ll need to know what your goals are and your time horizon for investments. They’ll be able to put together the portfolio that matches those needs.To meet the right advisor for you, contact us today. We’ll match your needs with the perfect professional on our list.