Absolutely, bonds can be a good investment if you buy and hold onto one for its entire term, earn a decent interest income, and the borrower doesn’t default. But there are a lot of things that can go wrong. In today’s world, you might run into liquidity problems, delayed payments, or even a default. The main risks in the bond market right now are credit risk and interest rate risk.
Let’s break these down:
1. Credit Risk: When interest rates are higher, the risks are higher too. For example, if the typical interest rate is 3% but you see one offering 8%, you need to take a close look at the borrower’s income, debt, and future prospects. For instance, Ted Hampton from Moody’s Investor Service highlights that unfunded pension liabilities are becoming a serious issue, using Illinois as an example.
What’s the worst that could happen? Bankruptcy or default, like what happened with Chrysler, General Motors, Delta Airlines, U.S. Air, United Airlines, and cities like New York (1975), Cleveland (1978), and Orange County, California (1994). In such cases, bondholders usually end up getting less than they are owed and much later than expected.
A slightly better but still bad scenario is illiquidity. If a state like Illinois keeps issuing bonds, it has to raise its interest rate to attract new lenders, which reduces the appeal of your 3% bond. You might end up holding onto the bond until it matures, hoping the issuer doesn’t default. But if you need to sell quickly in an emergency, you might have to sell at a very low price, if you can sell it at all.
2. Interest Rate Risk: When interest rates go up, the value of your bond generally goes down. With U.S. interest rates at historic lows, lower than inflation, they’re likely to rise. Countries like Canada, China, and those in the European Union have already started increasing their rates. This means high-risk bond issuers have to raise their rates to attract new borrowers, tying this into credit risk.
Given the current environment of rising interest rates and high debt levels among countries and companies, the market value of your bonds could drop, and it might be hard to find buyers if you want to sell. States can’t go bankrupt, but they can default on their bonds.
To keep your bond portfolio in good shape, you need to look at a few key things. These include fiscal health, yield rate, how much debt is tied up in municipal bonds, the longevity of companies, the revenue source for revenue bonds, and how diversified your funds are across different sectors. Remember, even seemingly safe bond funds can struggle if the entire industry takes a hit.
Stay mindful of credit and interest rate risks in today’s bond market. When evaluating your bonds, focus on shorter-term, higher-credit-quality ones and carefully review your portfolio.