Sure, bonds can be a safe investment if you buy one, hold onto it for its entire term, and get a decent interest income, provided the borrower doesn’t default. However, there are several potential risks involved. Nowadays, these risks can lead to liquidity problems, delayed payments, or even a default. There are two main risks in the current bond market: credit risk and interest rate risk.
Let’s break these down:
1. Credit Risk: Higher interest rates usually mean higher risks. If the average rate is around 3% and you’re offered 8%, it’s essential to closely examine the borrower’s income, debt, and future prospects. As noted by Ted Hampton from Moody’s Investor Service, unfunded pension liabilities are becoming more problematic and unmanageable, with Illinois serving as an example.
What’s the worst-case scenario? Bankruptcy or default, similar to past cases with Chrysler, General Motors, Delta Airlines, U.S. Air, United Airlines, and cities like New York, Cleveland, and Orange County, California. In bankruptcy court, bondholders often have to negotiate settlements and may end up getting much less than they were promised, much later than they expected.
The second-worst situation is illiquidity. If a state like Illinois issues bonds frequently, it must raise its interest rate to draw new lenders, diminishing the value of your 3% bond. Holding onto it until the end of its term and hoping for no default is one approach. However, if you need to sell it in a hurry during an emergency, you might have to sell at a very low rate—if you can find a buyer at all.
2. Interest Rate Risk: When interest rates go up, the value of your bond usually goes down. With U.S. interest rates currently at record lows and below inflation, they are likely to rise eventually. Countries like Canada, China, and those in the European Union have already started increasing their rates. High-risk bond issuers will need to raise their rates to attract new borrowers in line with credit risk.
In current times with rising interest rates and high debt levels in both countries and companies, your bonds’ market value might decrease. You might also find fewer buyers if you want to sell your bonds. While states can’t declare bankruptcy, they can default on their bonds.
Certain key factors can help guide the financial health of your bond portfolio. These include the fiscal health, yield rate, and indebtedness of Municipal Bonds, the longevity of corporations, the revenue sources of Revenue Bonds, and the diversification of your funds across different sectors. Even seemingly safe bond funds can suffer if the entire industry takes a hit.
So, be mindful of credit and interest rate risks in today’s bond market. When assessing your bonds, focus on those with shorter terms and higher creditworthiness, and diligently scrutinize your portfolio.