You should understand the different types of bond risks so there are no big surprises when you get your financial statements. These risks apply to every bond mutual fund on the market. You can save yourself a lot of stress by considering the risks before you invest.
I can give you a brief explanation of bond risks and how to minimize them so you can protect your investment. You can’t eliminate all of the risk when investing, but you can avoid making the most common mistakes. This will save you money in the long run.
When you loan money to anyone, there is a chance that you may not get all of your money back. A bond works in the same way. Default risk is the chance that a borrower will not repay the money on a bond. When you buy bonds, the bond issuer pledges that the investor will be paid back by a specific date. If someone cannot pay back the interest or principal on their bond, they are considered in default.
This is also referred to as credit risk, counterparty risk, or sovereign risk in certain situations. For bondholders, all of these terms mean the same thing: you may not get all of your money back. If you own a bond that is in default, you may get paid back anywhere between zero and the full value of your principal investment.
How can this happen?
Corporations may go bankrupt and not have enough money to pay bank investors on their corporate bonds. In the U.S. (and most other countries) there are laws governing the order in which creditors and investors are paid. This is called absolute priority; if a company is liquidated, bondholders (creditors) are paid out before shareholders.
Mortgage-backed bonds can go into default if the mortgage owners do not make their payments or go into foreclosure. This drastically affected the mortgage bond market in 2007 and 2008, when the value of many mortgage-backed bond portfolios collapsed.
State or local governments generally determine how much bondholders are compensated if they are unable to meet the full obligations on their municipal bonds.
For investors in bond mutual funds, this means the value investment may go down. Mutual funds are never a guaranteed investment, but the first important step to prevent your money from disappearing is to understand how these bond risks can affect your mutual fund. If you have doubts about whether a bond issuer will pay your mutual fund back, you may not want to invest in that fund.
Default risk is not easy to measure on a mutual fund, but you can try to minimize it. Each bond has a credit rating, which are like credit scores for companies and government entities. Just like your personal credit score, a bond’s credit rating can help indicate how well a borrower is able to pay back their bond.
Bonds have two separate groups for credit ratings:
Investment-grade bonds have a favorable credit rating, which means the company is expected to meet its obligations. These bonds generally pay normal interest rates.
Below investment-grade bonds have a lower credit rating. Investors may refer to these as junk bonds, and fund companies refer to these as high-yield bonds (because high-yield sounds better!). These bonds generally have more risk than investment-grade bonds, and pay higher interest rates.
Interest-Rate Risk and Prepayment Risk
Since bond interest payments are based on interest rates, bonds are also exposed to interest rate risk. When I refer to interest rates, I mean the percentage that the bond market is currently charging to lend out their money. In the United States, this percentage is set by the Federal Reserve Bank. Professional investors watch this percentage to help them determine how much to charge borrowers.
So how does this particular bond risk affect your mutual fund?
Let’s say you buy a bond paying a fixed interest payment, and interest rates go up in the bond market. This means you could have received a higher return on your investment. In this example, the value of your bond fund would decrease.
There is a simple way to remember this rule:
If interest rates go up, the value of your bond fund will go down. If interest rates go down, the value of your bond fund will go up.
The simplest and most common measurement of interest rate risk is a bond’s duration. A bond with a higher duration generally has more interest-rate risk. Bond funds with a lower duration generally have less interest-rate risk. For most investors, this is the most practical way to manage your interest-rate risk. The lower the duration, the better.
The last type of risk is prepayment risk. This is the chance that you may earn less interest if a bond is paid off early or refinanced. This is the only bond risk that does not involve losing money.
Prepayment risk is most common with mortgage-backed bonds, because homeowners tend to move or refinance a mortgage before the end of the mortgage term. It is less common for companies and governments to refinance their debt or pay off their debt sooner than expected. Most investors do not consider prepayment a serious risk, which explains why there is no simple measurement for it.
How to Minimize Bond Risks
Bond mutual funds try to decrease default risk by investing in a number of different bonds. The more diversified a bond fund is, the lower the risk. Unfortunately there is no exact measurement for default risk, but credit ratings are a good indicator of how well borrowers can pay back investors.
When you compare bond risks, make sure you are comparing funds in the same category. For example, don’t try to compare long-term bond funds with short-term bond funds. You will end up confused and frustrated. Each category has different risk levels and price movements.
Short-term bond funds generally carry less risk than long-term bond funds. This happens because it is much easier for the bond market to predict short-term interest rates. It becomes difficult when investors try to guess what interest rates will be 10 or 20 years from now.
The best way to avoid bond risks is to look for funds with a low duration and low turnover. A low turnover means that a bond fund makes fewer changes to its portfolio. These two statistics will lead you away from the funds that trade too often, invest in derivatives, or use leveraging. These strategies try to boost fund returns, but usually add more risk to your investment.