Why Bonds, Though Supposed to Be Fixed Income Investments, Have More Risks Than You Would Expect.
If there is something all investors want, it’s earning money without risk. Sadly, this is not possible, and nowadays low-risk investments are giving very low rates of profits. However, in periods like these last few months in which the stock market seems to be changing the up-trend to a correction, many investors are looking at bonds as the future place of their investments. One of the main reasons for this is to avoid the risks associated with the stock markets, but are they really so safe?
In comparison with stock markets, bonds (or at least bonds from solvent creditors) are safe, but they still have some risks that many investors ignore. When investing, you should be sure you understand the risks involved in the investment, and therefore denial is not your friend.
The first thing an investor needs to understand is that a bond listed in an exchange market is dependent on supply and demand impulses. Since the amount of money you are going to receive with a bond is fixed, you may expect that these changes are highly predictable. In principle, as long as the time passes, the interest is accrued. If it is not distributed, you could expect the value of the bond to raise, because the new investor would receive the same amount of money that the original investor expected time ago, but waiting less time.
As a result, when naive investors see that after a time their bonds have less price than when they bought it, they feel confused and disappointed. Why is this possible?
Bonds are very related to opportunity cost. In other words, while your money is invested in an investment, you can’t use it in any other thing, and as a result you can’t get profits from the other opportunities that may appear in the market.
Under those circumstances, the great enemy of bond investors is the raises in interest rates. If the interest rate raises, a new investor will be able to invest in other bonds or financial instruments, getting more money than investing in our old bond. As a consequence, if we want to sell our bond, we will need to lower its price. If the increase in interest is important enough, our bond can have less value than the original one we paid at the beginning, resulting in a loss.
We can keep the money invested until the end to receive the agreed interests of course, but we will be losing – or better said, preventing higher earnings – because of the opportunity cost.
So investment in bonds has the market risk associated with value oscillation, the liquidity risk associated with the possibility of not being able to sell the investment at the price we wish, and the insolvency risk that, although unlikely, we should always consider.
Now, this does not mean that bonds are a bad investment. We are only trying to clarify a common misunderstanding of them. In comparison with other investments, bonds are usually quite safe.
Please not the above does not represent financial advice.