Seasoned investors understand the value of diversity. Creating a portfolio that includes a variety of asset classes—stocks, currencies, derivatives, commodities, and bonds—is likely the most effective approach to achieving consistent returns.

Although bonds may not always deliver the highest yields, they are regarded as a dependable financial vehicle. That’s because they’re recognized to produce consistent income. However, they are also regarded as a reliable and secure option to invest your money.

However, this does not mean that they are without risks. As an investor, you should be aware of some of the risks associated with bond investments. Here are some of the most common dangers.

Basics of Bond Investing

Bonds are a form of debt issued by a company or government that wants to raise some cash. In essence, when an entity issues a bond, it asks the buyer or investor for a loan. So when you buy a bond, you’re lending the bond issuer money.

In exchange, the issuer promises to pay back the principal amount to you by a certain date and sweetens the pot by paying you interest at regular intervals—usually semi-annually.

Interest Rate Risk

When you buy a bond, you commit to receiving a fixed rate of return (ROR) for a set period. Should the market rate rise from the date of the bond’s purchase, its price will fall accordingly. If you sell it in the secondary market, the bond will then trade at a discount to reflect the lower return that the buyer will make on the bond.

This is why interest rates are said to have an inverse relationship with bond prices.

The inverse relationship between market interest rates and bond prices holds true under falling interest-rate environments as well. The originally issued bond would sell at a premium above par value because the coupon payments associated with this bond would be greater than the coupon payments offered on newly issued bonds.

As you can infer, the relationship between the price of a bond and market interest rates is explained by the changes in supply and demand for a bond in a changing interest-rate environment.

Market interest rates are a function of several factors including the supply and demand for money in the economy, the inflation rate, the stage that the business cycle is in, and the government’s monetary and fiscal policies.

Example of Interest Rate Risk

Say you bought a 5% coupon, a 10-year corporate bond that is selling at par value of the $1,000. If interest rates jump to 6%, the market value of the bond will fall below $1,000 because the 5% fixed interest that it pays grows less attractive as newly issued bonds will yield a full percentage point higher for bondholders. As a result, the original bond will trade at a discount in order to compensate for this difference.

Supply and Demand

Interest rate risk can also be understood in terms of supply and demand. If you purchased a 5% coupon for a 10-year corporate bond that sells at par value, you would expect to receive $50 per year, plus the repayment of the $1,000 principal investment when the bond reaches maturity.

Now, what would happen if market interest rates increased by one percentage point? A newly issued bond with similar characteristics as the originally issued bond would then pay a coupon amount of 6%, assuming it is offered at par value.

For this reason, the issuer of the original bond would find it difficult to find a buyer willing to pay par value for the bond in a rising interest rate environment because a buyer could purchase a newly issued bond that pays a higher coupon amount.

The bond issuer would have to sell it at a discount from par value. The discount would have to make up the difference in the coupon amount in order to attract a buyer.

Reinvestment Risk

Another risk associated with the bond market is reinvestment risk. A bond poses a reinvestment risk if its proceeds will need to be reinvested in a security with a lower yield.

For example, imagine an investor buys a $1,000 bond with an annual coupon of 12%. Each year, the investor receives $120 (12% x $1,000), which can be reinvested back into another bond. But imagine that, over time, the market rate falls to 1%. Suddenly, that $120 received from the bond can only be reinvested at 1%, instead of the 12% rate of the original bond.

Call Risk for Bond Investors

Another risk is that a bond will be called by its issuer. A bond can be issued with a call provision that allows the issuer the option to retire it early. The principal is repaid in full and the agreement to pay interest is canceled.

This is usually done when interest rates fall substantially since the issue date. The issuer can retire the old, high-rate bonds and issue a new round of bonds at a lower rate of interest.

Default Risk

Default risk is the possibility that a bond’s issuer will go bankrupt and will be unable to pay its obligations in a timely manner if at all. If the bond issuer defaults, the investor can lose part or all of the original investment and any interest that was owed.

Credit rating services including Moody’s, Standard & Poor’s, and Fitch give credit ratings to bond issues. Their ratings are an evaluation of the financial soundness of the bond issuer and are intended to give investors an idea of how likely it is that a default on its bond payments will occur.

For example, the U.S. and many other national governments have very high credit ratings. They have the means to pay their debts by raising taxes or printing money, making default extremely unlikely.

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However, some struggling nations have very low credit ratings, indicating that they are more likely to default on their bond payments. Their bondholders may lose some or all their investments.

Low-rated bonds are also known as junk bonds.

Inflation Risk

Just as inflation erodes the buying power of money, it can erode the value of a bond’s returns. Inflation risk has the greatest effect on fixed bonds, which have a set interest rate from inception.

For example, if an investor purchases a 5% fixed bond and inflation rises to 10% per year, the bondholder is effectively losing money on the investment because the purchasing power of the proceeds has been greatly diminished.

The interest rates of floating-rate bonds or floaters are adjusted periodically to match inflation rates, limiting investors’ exposure to inflation risk.

Municipal bonds are a popular choice for many people looking for a tax-efficient investment. Local governments issue these bonds, and the revenues are used to pay for public infrastructure projects including schools, roadways, and hospitals. While municipal bonds can offer great benefits, they also carry hazards.

1. Risk of Default: Municipal bonds are not immune to default risk. In some cases, local governments may be unable to repay the principal and interest on their bonds. This can lead to significant losses for investors.

2. Interest rate risk: Municipal bonds are sensitive to changes in interest rates. If interest rates rise, the value of existing bonds will decrease, and investors may experience losses if they need to sell their bonds before maturity.

3. Credit Risk: Municipal bonds are rated by credit rating agencies based on the creditworthiness of the issuing local government. If a local government’s credit rating is downgraded, the value of its bonds may decrease, and investors may experience losses.

4. Tax-Advantaged Returns: One of the most significant benefits of investing in municipal bonds is the tax-advantaged returns they offer. Interest income from municipal bonds is generally exempt from federal income taxes and may also be exempt from state and local taxes.

5. Diversification: Municipal bonds can be an effective way to diversify an investment portfolio. Since they have a low correlation with other asset classes, such as stocks and corporate bonds, investing in municipal bonds can help reduce overall portfolio risk.

6. Stability: Municipal bonds are generally considered to be a stable investment option. Local governments have a long history of repaying their debts, and the risk of default is relatively low.

When considering investing in municipal bonds, it is essential to weigh the risks and rewards carefully. While these bonds can provide attractive tax-advantaged returns and diversification benefits, they are not without risks.

As an investor, it is crucial to consider your investment goals, risk tolerance, and overall portfolio strategy. If you are considering investing in municipal bonds, it may be wise to consult with a financial advisor to determine the best approach.

Ultimately, the best option for investing in municipal bonds will depend on your individual circumstances and investment objectives. However, by carefully assessing the risks and rewards of this type of investment, you can make an informed decision that aligns with your long-term financial goals.

What are the Benefits of Investing in Municipal Bonds?

Bonds can be included in a diversified investment portfolio since they are less risky than equities, have lesser price swings, and provide a consistent income stream via interest payments. We commonly hear about Treasury and Corporate bonds, but today we’ll look at Municipal bonds.

If you invest in municipal bonds, you are lending to state and federal governments so that they can spend on public infrastructure projects such as airports, roads, and hospitals. Most municipal bond issuances generate interest income that is exempt from federal taxation and may also be exempt from state income tax if you live in the state that issued the bond. Remember, however, that the tax savings only apply to interest income, not capital gains if you sell the security.

The 3 ways you can invest in municipal bonds: new issuances, secondary markets or muni bond funds, such as a mutual fund or ETF. New issuance is for new projects being financed, whereas the secondary market is for buying bonds previously issued or selling bonds you hold which have not yet matured. Funds invest in a variety of muni bonds, to which you can get exposure by buying a portion of the fund. 

Be aware of interest rate risk if investing in muni bonds. If the interest rates rise after you purchase a muni bond, newer issuances with similar terms and structures may offer a higher yield and you may get a lower price if you sell your muni bond. 

Credit risk is also a factor to consider and each issuing state/municipality is given a credit rating by the 3 major agencies (Moody’s, S&P, Fitch) so guide in assessing credit and default risk. Although generally lower risk than corporate bonds, muni bond defaults are not unheard of (eg Puerto Rico in 2016).

One way to understand movements in the muni bond market is by looking at the municipals-over-bonds (MOB) spread, which is the relationship between a muni bond yield and the yield of a treasury bond with similar maturity. When muni bond spreads are rising faster than treasury spreads, the MOB spread widens. 

2020, amidst the COVID-19 pandemic, has been a volatile time for muni bonds. In March, the 10-year MOB spread surged to its highest rate since the 2008 credit crisis. Liquidity receded as investors withdrew from muni funds, amidst credit concerns. The economic impact of the pandemic caused investors to be cautious about the risk of default from states and municipalities. More recently in 2Q 2020, we have seen the Muni bond market rebound as the Fed has cut the Fed Funds rate and launched bond purchase programs which include municipal bonds. In July supply of newly issued bonds increased 31% above the 5-year average and similarly there was strong demand to absorb the new supply. 

Given this recent performance, and with supportive supply and demand fundamentals, the muni market feels relatively attractive in the near future. However, considerable uncertainty surrounds the economic effects of the pandemic, alongside the presidential election, which could cause further volatility, particularly for bonds financing projects related to senior living/long-term care facilities, hospitals and hospitality and travel. 

Evaluating the Potential of Municipal Bonds

1. Understanding the Risks and rewards of Municipal Bonds

Investing in municipal bonds can be an attractive option for investors seeking steady income and potential tax advantages. However, like any investment, municipal bonds come with their own set of risks and rewards that should be carefully evaluated before making a decision. In this section, we will delve into the key factors that investors should consider when evaluating the potential of municipal bonds.

2. Credit Risk: Assessing the Fiscal Health of Municipalities

One of the primary risks associated with municipal bonds is credit risk. Municipalities issue bonds to fund various projects such as infrastructure development, schools, or public utilities. Before investing, it is crucial to assess the fiscal health of the issuing municipality. This involves evaluating their ability to generate sufficient revenue to meet their debt obligations.

For example, if a municipality heavily relies on a single industry or taxpayer for revenue, such as a manufacturing plant or a large corporation, it may be more susceptible to economic downturns or changes in the industry. On the other hand, municipalities with diversified revenue streams, stable economies, and strong financial management are often considered more creditworthy.

3. Interest Rate risk: Navigating the Impact of Rate Movements

Another risk to consider is interest rate risk. When interest rates rise, the value of existing bonds typically decreases. This is because new bonds issued at higher interest rates offer investors better returns, reducing the attractiveness of previously issued bonds. Conversely, when interest rates decline, the value of existing bonds tends to rise.

Investors who plan to hold municipal bonds until maturity are less exposed to interest rate risk. However, those who may need to sell their bonds before maturity should carefully monitor interest rate movements to avoid potential losses. Diversifying the bond portfolio by investing in bonds with different maturities can help mitigate interest rate risk.

4. Default Risk: Evaluating the Likelihood of Non-Payment

While municipal bond defaults are relatively rare compared to corporate bonds, it is still essential to evaluate the default risk associated with a particular bond. Factors such as the issuing municipality’s financial stability, debt burden, and economic conditions should be considered.

For instance, during the 2008 financial crisis, some municipalities faced financial distress and struggled to meet their debt obligations. Understanding the underlying reasons for defaults and the steps taken to address them can provide valuable insights when evaluating municipal bonds.

5. Tax Advantages: Weighing the Benefits of Double Exemption

One of the significant advantages of municipal bonds is their tax-exempt status. Interest income from municipal bonds is generally exempt from federal income tax, and if the investor resides in the issuing state, it may also be exempt from state and local taxes. This double exemption can enhance the after-tax yield compared to taxable bonds.

For example, if an investor is in the 30% federal tax bracket and considering a municipal bond with a yield of 3%, the after-tax yield would be equivalent to a taxable bond with a yield of 4.29%. It is crucial to evaluate the potential tax advantages based on individual tax situations and investment objectives.

Evaluating the potential of municipal bonds requires a careful analysis of credit risk, interest rate risk, default risk, and the tax advantages offered. By thoroughly assessing these factors, investors can make informed decisions and potentially benefit from the steady income and tax advantages associated with municipal bonds.