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Are Bonds Risk Free?
Date Added: September 1st, 2005
Article provided by TeenAnalyst.com
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I've been thinking about investing bonds for some time now and I keep reading that they are "low-risk." Shouldn't they be considered no-risk? I'm referring to government bonds but I think it should apply to all bonds. Am I right? -Ajih, (Tampa, FL)
Thanks for the question and to answer it, bonds are low-risk. They're considered less risky and volatile than common stocks are. However, it's important to understand that there are some risks involved with investing in bonds. These can be broken down into two categories:
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Risk #1: Defaulting
If you buy corporate bonds, you are essentially buying a claim to their assets. Just as with individuals, corporations take on debt in hopes to grow. Sometimes they take on too much or their operations start to perform poorly and they are unable to repay their debts. This is just like someone taking on too much credit card debt and then having to file for bankruptcy. At times, companies will file for bankruptcy and won't be able to repay the principal on their debt. This means that the investor can theoretically lose their entire investment, although this is not a particularly common occurrence. When companies do this (called "defaulting"), bond investors typically show up in bankruptcy court to divvy up the assets and recover as much money from their investment as they can.
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Risk #2: Changing Interest Rates
When you invest in a bond, you can sell it on the market at any time. And like a stock, each bond has a certain price that the market assigns to it. Because you might end up selling it on the open market, you have to understand that people not only care what interest rate the bond pays but also the interest rate that the market currently has. For example, if you own a bond paying 6% interest and you want to sell it one year later on the open market when the interest rate is 8%, you're going to get a lower price than what you paid. After all, why would anyone buy your 6% bond if they could get a new 8% bond? The only way they will do it is by buying your bond at a discount.
The longer you hold your bond, the less likely you are to lose money on it. And bonds are typically a long-term investment, so this shouldn't really be a big concern for you.
Tips to Avoid Risk
If you invest in corporate bonds, make sure you read up on what their current bond rating is. A bond rating is basically a letter grade assigned to each bond to tell investors how risky it is. If you want to avoid risk, stay away from "junk" bonds.
Also, to help avoid the chance of losing money on a bond because of changing interest rates, don't buy bonds when interest rates are low. The higher the interest rate rises, the lower the price of your bond will fall.
In general, stick with bonds for the long-term and try to invest in them when you think the interest rate is reasonable. This will help you maximize your returns and minimize your risk.
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Bond Ratings
Each bond is given a rating that helps investors understand the risks involved. And with greater risks come greater returns.
Bonds, Notes, and Bills
There are three different names for treasury securities based on their maturities. This article explains them.
Savings Bonds
This article explains a little about savings bonds, which are still a common investment.
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Another Great Site!
Be sure to head over to TeenAnalyst for lots of great investment articles!
TeenAnalyst.com
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