Fixed income is generally considered to be a more conservative investment than stocks; however, investors should still be aware of the potential risks that bonds and other fixed-income investments may carry.
Fixed income* is generally considered to be a more conservative investment than stocks, but bonds and other fixed income investments still carry a variety of risks that investors need to be aware of. Diversification can be a good way to minimize many of the risks inherent in fixed income investing. In the world of fixed income, diversification takes on many forms, including diversification across bond type, bond issuer (such as the federal or a provincial government, or a corporation) and bond duration (short-, intermediate-, and long-term bonds), or credit quality and yield (high-quality bonds are relatively safer but pay lower rates, while less creditworthy issuers will pay higher rates for greater risk). Bond funds can also provide professional diversification for a lower initial investment. But the securities held in bond funds are all still subject to several risks that can affect the health of a fund.
Interest rate risk
Investors don’t have to buy bonds directly from the issuer and hold them until maturity. Instead, bonds can be bought from and sold to other investors on what’s called the “secondary market.” Bond prices on the secondary market can be higher or lower than the face value of the bond, depending on the economic environment and market conditions, both of which can be affected significantly by a change in interest rates. If interest rates rise, bond prices usually decline. That’s because as interest rates increase, new bonds are likely to be issued with higher yields, making the old or outstanding bonds less attractive.
If interest rates decline, however, bond prices usually increase, which means an investor can sometimes sell a bond for more than face value, since other investors will be willing to pay a premium for a bond with a higher interest payment, also known as a “coupon.”
If you decide to sell a bond before its maturity, the price you receive could result in a loss or gain, depending on the current interest rate environment. The longer a bond’s maturity – or the longer the average duration of a bond fund – the greater the impact a change in interest rates can have on its price. In addition, zero‐coupon bonds, or those bonds with lower coupon (or interest) rates are more sensitive to changes in interest rates, and the prices of these types of bonds (or the bond funds or ETFs that hold these bonds) tend to fluctuate more than higher‐coupon bonds in response to rising and falling rates. However, if you’re holding a bond until maturity, interest rate risk is not a concern.
Credit risk
Bonds carry the risk of default, which means that the issuer may be unable or unwilling to make further income and/or principal payments. In addition, bonds carry the risk of being downgraded by the rating agencies, which could have implications for the price. Most individual bonds are rated by a credit agency such as Moody’s or Standard & Poor’s (S&P) to help describe the creditworthiness of the issuer or individual bond issue. Canadian government bonds have backing from the Canadian government and, as such, are considered to have an extremely low risk of default – although Canadian government bonds can still be downgraded from their top‐notch status in times of economic or political difficulty. Since all bonds are evaluated relative to government bonds, this can affect the credit quality of other generally highly rated bonds, such as agency bonds.
Bonds are typically classified as investment-grade quality (from medium to the highest credit quality) or non-investment-grade (commonly referred to as high-yield bonds). Bond funds and bond ETFs are not themselves rated by the agencies, but the investments they hold may be. You can find out the quality of a fund’s investments by reading the fund’s prospectus.
Credit risk is a greater concern for high‐yield or non-investment-grade bonds and bond funds that invest primarily in these lower‐quality bonds. Some bond funds may invest in both investment-grade and high‐yield bonds. It’s important to read a fund’s prospectus before investing to make sure you understand the fund’s credit quality guidelines.
Since bond funds and bond ETFs are made up of many individual bonds, diversification can help mitigate the credit risk of an issuer defaulting or being downgraded, which would affect bond prices. An investment-grade bond fund will typically have no less than an 80% allocation to investment-grade bonds, while a high-yield bond fund will typically have the majority of the portfolio’s assets invested in non-investment-grade bonds.
Inflation risk
Inflation risk is a particular concern for investors who are planning to live off their bond income, although it’s a factor everyone should consider. The risk is that inflation will rise, thereby lowering the purchasing power of your income. To combat this risk, you may want to consider inflation-protected securities. The principal for inflation-protected securities is adjusted for any rise in the Consumer Price Index, so when the bonds mature and the principal is returned, that amount will be higher, to correspond with the amount of inflation. (Inflation-protected securities do not adjust at all if inflation decreases over the life of the bond.) Because this inflation factor is a component of the interest payment calculation, interest payments for inflation-protected securities are variable, even though the coupon is fixed. There are bond funds that invest exclusively in inflation-protected securities, as well as some that use these securities to offset inflation risk that may affect other securities in the portfolio.
Call risk
A callable bond has a provision that allows the issuer to call, or repay, the bond early. If interest rates drop low enough, the bond’s issuer can save money by repaying its callable bonds and issuing new bonds at lower interest rates. If this happens, the bondholders’ interest payments cease, and they receive their principal early. If the bondholders then reinvest the principal in a bond of similar characteristics (such as a similar credit rating), they will likely have to accept a lower interest payment (or coupon rate), one that is more consistent with prevailing interest rates. Therefore, the investors’ total return will be lower, and the related interest payment stream will be lower – a risk that is more serious for investors dependent on that income.
Before purchasing a callable bond, investors should not only evaluate the bond’s yield to maturity (YTM) but also take account of the yield to call or the yield to worst (YTW). Yield to worst calculates the worst yield from the two potential outcomes: either that the bond runs through its stated maturity date or that it is redeemed earlier. See “Bond prices, rates and yields”.
Prepayment risk
Some classes of individual bonds, including mortgage-backed bonds, are subject to prepayment risk. Similar to call risk, prepayment risk is the risk that the issuer of a security will repay the principal before a bond’s maturity date, thereby changing the expected payment schedule of the bond. This is especially prevalent in the mortgage-backed bond market, where a drop in mortgage rates can initiate a refinancing wave. When homeowners refinance their mortgages, the investor in the underlying pool of mortgage-backed bonds receives his or her principal back sooner than expected, and must reinvest at the lower prevailing rates.
Liquidity risk
Liquidity risk is the risk that you might not be able to buy or sell investments quickly for a price that is close to the true underlying value of the asset. When a bond is said to be liquid, there’s generally an active market of investors buying and selling that type of bond. Canadian government bonds and larger issues from well-known corporations are generally very liquid. But not all bonds are liquid; some trade very infrequently (e.g., provincial bonds), which can present a problem if you try to sell before maturity: the fewer people there are interested in buying the bond you want to sell, the more likely it is you’ll have to sell for a lower price, possibly incurring a loss on your investment. Liquidity risk can be greater for bonds that have lower credit ratings (or were recently downgraded), or bonds that were part of a small issue or sold by an infrequent issuer.
Weighing the risks of individual bonds vs. bond funds and bond ETFs
Diversification
Because bond funds and bond ETFs are generally diversified across multiple securities, a single purchase made with a limited investment amount can provide access to potentially hundreds of different issuers. This can help lessen the downside impact from a credit event that affects any one of the issuers.
Liquidity
The liquidity risk described above can be more exaggerated with a single bond. In certain cases, there may not be an active two-way market for a specific bond. With a bond fund, on the other hand, the investor has access to buy or sell at the end of the day, and with a bond ETF, throughout the market trading day.
Return of principal
With individual bonds, so long as the issuer does not default, an investor will be paid the bond’s par value when the bond matures. A bond fund or bond ETF on the other hand, does not mature, and its value will fluctuate. While a single bond’s price can fall, the investor has an option to wait until it matures or is redeemed.
Income predictability
For an individual bond, the future cash flows from coupons and principal payments are contractually transparent and can be predicted – with a caveat regarding insolvency of the issuer, as described above. With a bond fund or bond ETF, because the underlying holdings are bought and sold, the income that they generate in the aggregate will fluctuate over time and can not be known in advance.
