For many investors, bonds are more mysterious than stocks. Most people know that a bond is a loan and you are the lender. Who’s the borrower? Usually, it’s either the U.S. government, a state, a local municipality or a big company like General Motors. All of these entities need money to operate — to fund the federal deficit, for instance, or to build roads and finance factories — so they borrow capital from the public by issuing bonds.
There are several risks that you take when you buy a bond (or to put it another way, lend your money).
- The first risk that you need to be concerned about is “credit risk.” This is the risk that the bond issuer (the borrower) can’t pay the interest or principal back. You may know how that works if you lend money to a friend. It works exactly the same way in the bond world. If a bond issuer can’t pay, the bond is said to be in “default.” At that point you cannot be sure if you will get any of your money back.
- A second risk with bonds is known as “interest rate risk.” When a bond is issued it has a stated interest rate which is usually fixed for the life of the bond. If interest rates go up during the bond’s lifetime, the value of the bond will go down. If you need to sell it during this time you may get back less than you paid.
- A third risk is the erosion of your “purchasing power.” When you buy a bond, your money has a known purchasing power. As an example, you know that you can get a cup of coffee at most places for about $1.25 (more at Starbucks) . If you buy a bond that does not come due for 30 years you can be fairly sure that that same cup of coffee will cost a lot more due to inflation. Yet if you buy the typical bond for $1000, you will get back $1000 at maturity and that may not buy nearly as many cups of coffee. That lost purchasing power needs to be offset by the interest payment you receive.
This is a greatly simplified discussion of bond risk, but it gives you a starting point to try to determine how bond investing should be viewed.