Are Bonds a Safe Investment?
By Ian Aguilar
For most investors at or nearing retirement, bonds have long been a place where you can go to get a secure and predictable stream of income. That experience that many have gone through since the 1980s is now being questioned as to whether it will continue for the years to come. The bond market through the first 3 quarters of 2022 has been historically bad and some would say doesn’t seem to offer much hope for the “bond-like” returns that we’ve grown accustomed to.
So, with many investors having been taught to use bonds as the safety portion of their portfolio, the question now becomes, are bonds still a good place to safely invest? Can bonds be additive and still function as one of the building blocks behind the 60% Stock and 40% Bond retiree portfolio that many would view as a typical portfolio for that demographic?
What Drives Risk & Returns in Bonds
To answer this question, it’s important to understand where the main drivers of risk come from when you as an investor own one. When investing in bonds there are 3 main ways in which we experience risk that culminates together in making the drivers of return when owning them.
Credit Risk
When you own an investment that mandates an entity (e.g. the US Treasury, the City of Jacksonville, or Johnson & Johnson) is going to pay you interest over the period in which you own it; then naturally there is always going to be a risk that this entity won’t have the ability to make that payment. Since bondholders are first in line to get paid in relation to other capital investments, a company would be considered bankrupt if they aren’t able to make payments on their bonds. That’s why so many people also consider credit risk akin to default risk.
Credit risk is often viewed by investors as the main driver of performance when owning a bond. In fact, multiple agencies rate the credit risk of individual bond issuances. Standard and Poor’s is one of the more widely used ratings and abides by the following chart when assigning grades to bond-issuing entities.
The lower the rating, the more likely you are to receive a higher interest rate for owning that bond. The exchange for more risk often drives returns. With that said, returns can still be had in bond-issuing entities that have extremely strong credit ratings. A great example would be US Treasuries. Often considered some of the safest assets in the world because of their strong credit rating, US Treasuries can still provide returns. Those returns are typically generated via other forms of risk outside of credit risk though.
Interest Rate Risk & Duration Risk
Interest rate risk speaks to the relationship that exists between bond prices and interest rates. As I outlined in a previous post , interest rates generally have an inverse relationship with current bond prices. So, as rates increase, bond prices typically tend to fall. This happens because of supply and demand. If a bond doesn’t generate as much income as other bonds, then the demand for that bond drops, and in turn the price.
Duration risk measures how certain bonds are more price sensitive than others when rates move. So, for a bond to have higher duration risk the price of that bond can either benefit from a movement lower in interest rates or suffer should rates move higher. Typically, bonds that have a longer payback period are those that are most price sensitive to changes in interest rates. When trying to find safety within bonds, you’ll likely look to limit duration risk by finding bonds that have a shorter payback period. It also generally means that you’ll be less compensated for that fact.
Reinvestment risk
The final risk factor I’m going to hit on is the concept of reinvestment risk which exists when an investor is not able to reinvest cash received from the sale or maturity of an investment at a comparable rate to what they previously had. In an environment where interest rates tend to be rising, the risk isn’t in relation to the income side of a bond since a reinvestment would be able to garner higher rates. However, there is reinvestment risk that exists when looking at how bond prices react to rising rates.
That exists because if you sell your current bond investment to get the higher interest rate that may be found in the marketplace, it may appear to be beneficial from an income perspective, but you have to sell what you already own. Since that is most likely at a discount due to lower demand caused by similar higher-yielding bonds elsewhere, the reinvestment into higher-yielding bonds may not make out ahead because of the reinvestment process that had to take place in order to buy the new bonds.
This dilemma is why we see so many bond funds struggle in a rising rate environment because when they sell their old bonds to buy new ones, they are incurring capital losses in order to increase the income that their fund produces. One way to avoid this issue is by owning individual bonds through maturity since bondholders are contractually promised the full principal of their bonds at maturity. So, even if a bond loses value temporarily due to changes in rates, the value of that same bond will come back to its base value by the maturity date. The key to preserving the principal value of an individual bond is that the investor must be willing to hold their bond to maturity.
How to Make the Determination if a Bond is Safe?
After looking at all the risks that were just highlighted, you may have a desire to strip out most of the credit risk, interest rate risk, duration risk, and reinvestment risk, but then what would remain would be an investment that most likely wouldn’t generate much in the way of returns, especially in relation to inflation. Instead, what bond investors are typically tasked with is determining which of these risks they are comfortable with and to what degree, in order to determine the appropriate investment.
Most retiree investors look to bonds to provide steady returns and income in a majority of investment environments. Bonds typically deliver on that expectation, but with changing macroeconomic conditions it can make the steadiness element more difficult. The key takeaway is that bonds are still worth owning as a main component in a portfolio, however, investors need to be aware of the previously highlighted risks that they set to take with each bond investment. It’s especially important to note that those risks can be elevated at points in time.
Credit risk has more of an impact on price in times of economic distress. Whereas, during times of more certain economic growth, the spread in income between an investment grade bond and a distressed bond can shrink and the returns generated may be less meaningful.
Interest rate risk and duration risk tend to be more pronounced during times of longer-term changes in interest rates. If rates bounce around and ultimately end back up where they started, then the bondholder likely wouldn’t feel any financial hardship other than having to deal with some price volatility. The long-term direction of interest rates tends to come and go in cycles. As mentioned before, we have generally seen a trend of lower interest rates since the 1980s. If that were to reverse, interest rate risk and duration risk would become more pertinent.
Reinvestment risk is most apparent in a rapidly shifting rate environment. If rates look drastically different than they did before, the difficulty of effectively having to redeploy capital back into the market becomes elevated since it can leave you either taking substantially less income in a falling rate environment, or taking a loss on your current bonds in order to achieve a higher income in a rising rate environment. Put simply, swift changes in rates can make it a difficult time for bond investors.
Conclusion
As with all investments, bonds are just another arrow in the quiver for an investor to create the appropriate portfolio for a particular risk tolerance. There are times when it can become challenging to find an acceptable or compelling set of risk/return characteristics from bonds, but still, they serve a great purpose for many investors and likely will for some time to come.
The calendar year of 2022 has shown that not all bonds are safe, especially in a rising rate environment, which as mentioned before can drive bond prices downward. However, given that this type of market is more of the exception rather than the rule, there are still ways that investors can tap into bonds to provide a relatively safe and stable income. The task for the investor is to determine which of the above outlined risks makes the most sense to take on to generate returns from their bonds.
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