Bonds Are Guaranteed, But Are They Risky?
Bonds, Are they Safe? Bonds are always issued as a guarantee, but there are substantial risks hidden within this guarantee. Credit/default risk is the question of whether or not the company or government will be able to pay you back as they have promised. They must pay you back, but if they don’t have the money to do so, then they will not be able to.
If it is a country who has issued a bond in their own currency, that country will often just print more money in order to pay you. (In Spring, 2010 we saw big problems arise in Greece because they are no longer able to just print their own money. The European Central Bank decides when new Euros are printed, so Greece actually had to pay its debts with real money and couldn’t.) This increases currency risk, but means they have very little default risk.
States, cities, and companies don’t have the ability to print their own money so their default risk is very real and should be considered carefully before you lend your money to them. The ratings agencies rate the debt and based upon these ratings, the company or government pays a higher or lower interest rate. The lower the risk of default is seen to be, the lower the interest rate that the market will demand.
Most bonds that most Americans buy have no currency risk because they are issued in the US in US Dollars. Thus any changes to currency values in the world has no impact on the amount of Dollars that you would receive from the bond issued in US Dollars. However, if the US Dollar does fall dramatically, the these future dollar payments will be just as unable to fulfill your needs as other US Dollars which you have.
If you are buying a bond denominated in a foreign currency, then you are exposed to that currency’s exchange risk. If the Dollar becomes much stronger against that particular currency (either because it strengthens in general or if because the particular country that you have invested in suffers a dramatic fall) then you might receive the exact number of pesos/euros/rubles/etc that you had been promised, but that might equate to far fewer US Dollars than you had anticipated. This is Currency risk.
On the other hand, if the US Dollar falls in value relative to the currency that your bond is issued in, you will receive the same number of pesos/euros/rubles/etc that you had been promised, but that might equate to far more US Dollars than you had anticipated when you originally lent the money. Of course, if you have a specific opinion on the long term direction on the US Dollar vs the currency in question, you can use this to your advantage (if you are correct in your opinion!)
Interest rate risk
The last bond risk that we will discuss is interest rate risk. Imagine that you have bought the 30 year bond from McDonald’s mentioned above paying 5% annually. What if we enter a period of rising interest rates and inflation such as the late 1970’s and similar bonds are now being issued at 15%? The 5% that you are receiving is now able to buy you less and less goods each year, so you are suffering even though it is paying you exactly what it promised.
However, if you sell the bond, who will want to buy it? Would you buy a bond paying 5% if the new bonds McDonald’s was issuing pay 15%?
Well Yes, you would! But only if you could pay far less than the original face amount for the bond. For instance, you would be thrilled to pay $1000 for this bond that pays you $250 each 6 months and will return $10,000 to you at the end of the 30 years! That’s an extreme example, but this affect is exactly what happens. The value of your bond is very much determined by the prevailing interest rates at the time you want to sell it.
So if interest rates in the market have gone down since you bought your bond, you will be able to sell the bond for more than you paid for it (assuming all else is equal). If interest rates in the market have gone up since you bought your bond, you not be able to get your principal back when you sell the bond. This is interest rate risk. Some bonds will be issued at floating rates which can alleviate some of this pressure, but most are not.