Five Risks Associated With Investing In Bonds |

With the stock market continuing its ascent in what has been a violent roller coaster ride over the past two years many people are holding the majority of their investment money in cash and money market accounts. The problem for these investors is that interest rates on cash and cash equivalents have fallen to almost nothing, with 78% of money market funds paying less that one-tenth of one percent in annual interest. Holding $1000 in an average money market account right now will get an investor a measly 8 cents in interest every month.

 Because investors want some return without all the risk of the stock market, many are turning to bonds as a middle ground between holding cash and owning stocks. Bonds have traditionally been considered a “safe” investment but there are risks with bonds that could hurt investors if certain factors occur. Here are some of the risks you should address before buying any kind of bond.

Default Risk: If the issuer of the bond goes bankrupt or out of business, the lenders sometime lost out. As a bondholder, you’re holding a debt instrument that the issuer originally used to borrow money. Bonds are rated based on the financial strength of the issuer but these ratings aren’t always perfect. The safest bonds have the strongest financial backing. The safest bonds out there are government treasuries, but the interest rates on treasuries aren’t much better than the rates on cash right now.

Interest Rate Risk: If market interest rates change, the value of your bonds will be affected. We are currently in a very low interest rate environment. When rates start to rise, bond values will fall. If your bond is several years from maturity, you’ll see the value fall by a larger amount than for a short term bond. Because interest rates are likely to go up in the next couple of years, your best bet right now is to buy short term bonds in most cases.

Call Risk: Some bonds have a feature that allows the issuer to call in their debt prior to its maturity date. A callable bond is risky because if the issuer decides to repay bondholders early, they must reinvest that money at current rates, which could be much lower than the interest rate was on their callable bond.

Political Risk: One of the policies that many people believe will change with the Obama administration is the tax code. If taxes increase, you could owe more of your interest income to Uncle Sam in the form of taxes. Municipal bonds, or tax free bonds, are one solution that might make sense to minimize this risk.

Market Risk: Bonds trade between investors just like stocks do. This means that most bonds are liquid but the market value of these bonds fluctuates day to day. The price of a bond is determined by how much demand there is for that particular type of bond. Government bonds have been profitable for investors recently because so many people want safe bonds that demand has been strong. Bonds in banks, for example, over the last few years, have seen their value fall because there are not a lot of investors willing to take on the default risk associated with banks.