Investing in equities has always been thought of as more risky than bonds. However, investing in bonds is not without risks. These are the top 5 risks involved in investing in bonds.
1.Income received from investor is fixed
There is a fixed upside in income with bonds. When an investor invests in a bond, they will receive a pre-determined fixed payment. Whereas in equity investment, if a company has an increase in profit, they may decide to pay this out to investors in the form of an increased divided. Hence there is limited upside with income in fixed income instruments but unlimited upside in income and capital growth with equities.
2.Interest rate rises
When bond yields rise, the bond price decreases. We talked about the reasons why there is an inverse relationship between bond yields and bond prices in “The relationship between bonds, interest rates, and stocks”. Bond yields are at very low level at the moment so should yield start to rise, then bond prices will fall significantly. This means that any bond investors who need to sell their bonds before maturity date may be selling their bonds at a price lower than when they purchased it.
3.Default Risk
Investors who are investing in high risk government bonds or corporate bonds are exposed to credit/default risk. This means that there is a risk the government or corporation is unable to pay back the loan to the investor. Hence these bonds usually have a higher yield in order to compensate for the higher risk involved in these instruments.
4.Inflation Risk
Coupon payments from bonds are fixed. If inflation is rising each year but these coupon payments stay the same, the investor has less purchasing power each year. When the principle is repaid at maturity date the inflation risk also diminishes the purchasing power of this repayment. That is, the investor may have been able to buy more with that money when they first bought that bond compared to what they could buy with that money at maturity date.
5.Underperformance
Equities have historically outperformed bonds. Bonds do not offer capital growth like equities and their upside is limited. Companies can use retained earnings to reinvest in the company to increase these earnings. However, the total return from bonds is limited. Bond investors make money by holding bonds until maturity and receiving all the coupon payment before maturity or they can sell the bond before maturity date at a bond price which is higher than what they initially paid for.
Lauren Hua is a private client adviser at Fairmont Equities.
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