Protecting Your Fixed Income Investments from Permanent Losses

Investing in bonds can be an important part of any family’s portfolio thanks to the stream of interest income they generate, not to mention your bond investments can help society by funding schools, hospitals, factories, and bridges. For new investors, there are six major risks that you need to consider before you purchase a bond for your brokerage account. Though by no means an exhaustive list, paying attention to these six can help you avoid many of the hazards that result in painful losses and sleepless nights.

1. Bond Investment Risk 1: Default

A bond represents a loan an investor makes to an institution, company, government, municipality, non-profit, or other entity. Any time you lend money, the creditworthiness of the borrower is of paramount importance. You want to ensure that not only do you receive your principal back in full on the maturity date, but that the borrower (the bond issuer) doesn’t miss any interest payments. One way to do this is to look at the balance sheet and income statement. This will allow you to get an idea of the issuer’s liquidity. You can also calculate financial metrics such as the interest coverage ratio. which is a general gauge of bond safety.

It is an old axiom on Wall Street — one often forgotten — that can best be paraphrased by a quip written by the father of value investing. the legendary Benjamin Graham himself: More money has been lost reaching for a little extra yield than stolen at the barrel of a gun. Riskier bonds pay higher interest rates. The risk that comes with those higher payments is real. It doesn’t do you a lot of good to collect a little more interest in exchange for giant losses down the road.

2. Bond Investment Risk 2: Inflation

When you buy a bond, lending money to the issuer, you are effectively going short the currency. You are giving up money today for the promise that you will get it back at some point in the future. The problem? History has shown politicians love to promise more benefits than taxpayers are willing to fund, meaning more money gets printed (metaphorically, anyway, as these days it is now mostly electronic).

That means the value of each unit of currency (in the case of the United States, the dollar) depreciates over time. Small depreciation rates each year can stagger the mind over many decades. Consider that a mere 4% inflation for 100 years, which is low by global and historical standards, would result in $1.00 being worth less than $0.02 by the end of the period; a loss of 98% of purchasing power.

3. Bond Investment Risk 3: Interest Rate Risk

Bond values can fluctuate wildly with changes in interest rates. The level of fluctuation depends on something known as bond duration. A bond maturing in 30 years can be as volatile as a stock, whereas one maturing in six months isn’t going to be nearly as effected. Your age, level of wealth, and expected liquidity needs all influence the appropriate duration of the aggregate bond exposure in your portfolio. One way to mitigate interest rate risk is a technique called a bond ladder. which is something every new investor should know by heart.

4. Bond Investment Risk 4: Reinvestment

Unless you are talking about something like a Series EE savings bond. which is structured under a so-called zero coupon repayment term where you buy the bond at a discount and it matures at a higher value so you earn interest equivalent without actually receiving interest checks, your bonds are going to present something known as reinvestment risk. Reinvestment risk is the danger that you won’t be able to put your interest income back to work at the same rate of return, or higher, you are earning on your original bond.

Think of an investor who was sitting on a portfolio of bonds back in the early 1980’s, collecting 15% or 20% on his or her money. Over the next few decades, as interest rates fell, it was only possible to put that money into new bonds earning a few percentage points.

What is an investor to do? What makes it tricky is that many of the techniques that can lower reinvestment risk, such as buying zero coupon bonds, result in higher interest rate risk (savings bonds excluded as a result of their unique on-demand maturity feature ). It’s a matter of picking your proverbial poison, which is the reason a qualified advisor can be so valuable.

5. Bond Investment Risks 5 & 6: Currency Risk and Political Risk

The next two risks are discussed in an article about the dangers of investing in foreign bonds. If you buy a bond or bonds outside of your home country, you face all sorts of potential pitfalls that aren’t present for domestic fixed income securities. While this can sometimes pay off, it can just as often lead to a lot lost money. Take the time to read that article to understand the exposures and it can save you a lot of hardship.