Are Bonds a Safe Investment Option?

Bonds can be a safe bet if you buy one, hold onto it until it matures, earn a decent interest, and the borrower doesn’t default. However, there are potential pitfalls, especially in today’s environment where issues like liquidity, delayed payments, or even defaults are more common. The two main risks in the bond market today are credit risk and interest rate risk.

Let’s explore these risks:

1. **Credit Risk**: Higher interest rates usually signal higher risk. If typical rates are around 3% and you’re offered 8%, it’s crucial to examine the borrower’s income, debt, and future stability. As Ted Hampton from Moody’s Investor Service highlights, unfunded pension debts are becoming a big problem, like we’re seeing in Illinois.

In the worst-case scenario, we’re talking bankruptcy or default, as happened with companies like Chrysler, General Motors, and Delta Airlines, and cities such as New York in 1975. In these situations, bondholders often have to negotiate in bankruptcy court, receiving far less than they were supposed to and much later.

The next worst thing is illiquidity. For instance, if a state like Illinois frequently issues bonds, it might have to increase interest rates to attract investors, which makes your 3% bond less appealing. You could keep your bond until it matures and hope the issuer doesn’t default. But if you need to sell quickly in an emergency, it might be hard to find a buyer, and you could end up selling for much less.

2. **Interest Rate Risk**: As interest rates rise, the value of your bond typically falls. Currently, U.S. interest rates are at historic lows, even below inflation, so they’re expected to go up eventually. Countries like Canada, China, and those in the EU have already started increasing rates. This means issuers of risky bonds need to offer higher rates to attract new investors in line with the credit risk.

Given the current scenario of rising rates and high national and corporate debt levels, your bond might lose value, and it might be harder to sell. While states can’t declare bankruptcy, they can default on bonds.

To maintain a strong bond portfolio, pay attention to fiscal health, yield rates, the debt level of municipal bonds, company longevity, revenue sources, and how diversified your investments are. Keep in mind, even seemingly secure bond funds can struggle when the entire industry is under pressure.

In today’s bond market, it’s essential to keep an eye on credit and interest rate risks. When managing your bonds, focus on short-term ones with high credit-worthiness, and regularly check your portfolio.