Risks of Bond Investing
Factors to consider when investing in bonds
Fixed income securities represent an asset class of securities offering investors defined cash flows and a specific time line for return of principal dollars invested. In general, specific characteristics define bonds as one of the most predictable asset classes and thus more conservative means to protect an investor's wealth and/or provide steady income. Still, there are risks and benefits associated with any investment which need to be understood in order to meet individual needs and investment suitability.
Professional advice and, in many cases, professional management, are key elements of successful financial planning. Although there is no assurance any investment strategy will be successful, our financial advisors assist investors in creating diversified fixed income portfolios designed to perform well in unpredictable market environments while addressing the investors' specific objectives for level of income and principal preservation.
Discussed below are considerations of benefits and risks associated with investing in fixed income securities. Additional information about these topics is available through many industry organizations such as: finra.org, emma.msrb.org, and investinginbonds.com. Asset allocation and diversification do not ensure a profit or protect against a loss. Investment suitability must be determined for each individual investor. Market prices of fixed income securities may be affected by several types of risk, including, but not limited to credit risk, interest rate risk, reinvestment risk, and liquidity risk. Investing involves risk and investors may incur a profit or loss.
- Credit Risk
- Default Risk
- High-yield Bonds
- Interest Rate Risk
- Reinvestment Risk
- Liquidity Risk
- Underlying Ratings
- Redemption Provisions
- Estate Protection Feature
- Original Issue Discount (OID)
- Purchasing Power Risk
- Step-up Coupon Securities
- Variable Coupons
- Zero Coupon Bonds
- Foreign Bonds
Risks: All bonds are subject to risk. Risk could be considered as a financial measurement tool to help an investor optimize return expectations. No two investors have identical situations and therefore may have very different risk tolerance levels. Identifying this tolerance level is very important in order to protect one’s assets but also to prevent underachieving return on investment.
Credit Risk: In order to help investors assess the credit worthiness of an obligor, independent nationally recognized statistical organizations, also called rating agencies, offer appraisals of the financial stability of a particular issuer and its ability to pay income and return principal on an investment. Moody’s, S & P and Fitch are the better known rating agencies that assign a specific rating indicating the degree of risk an investor acquires by owning debt in a particular obligor’s name. Generally, bonds with a lower credit ranking indicate a higher potential for financial risk and will generally command a higher yield associated with an offering. Conversely, bonds with a higher credit ranking indicate less likelihood for financial difficulties and generally provide a lower yield to an investor. The absence of a rating may indicate that the issuer has not requested a rating evaluation, insufficient data exists on the issuer to derive a rating, or that a rating request was denied. Non-rated securities tend to be more speculative in nature and are less liquid. Raymond James trade confirmations, online accounts and monthly statements display only the ratings of those rating agencies to which Raymond James subscribes. For more information on ratings, please visit Moodys.com, Standardandpoors.com and fitchratings.com.
Although rating agencies assist in evaluating the creditworthiness of an issuer, ratings are not recommendations to buy, sell or hold a security, nor do ratings remove market risk. In addition, ratings are subject to review, revision, suspension, reduction or withdrawal at any time, and any of these changes in ratings may affect the current market value of your investment. A rating agency may also place an issuer under review or credit watch which may be another indicator of a future rating change.
Default Risk: This is an obligor’s inability to remain solvent and pay any outstanding debt obligations in a timely manner. Adverse changes in the creditworthiness of the issuer (whether or not reflected in changes to the issuer’s rating) can decrease the current market value and may result in a partial or total loss of an investment.
High-yield bonds, those rated below investment grade, are not suitable for all investors. The risk of default may increase due to changes in the issuer's credit quality. Price changes may occur due to changes in interest rates and the liquidity of the bond. When appropriate, these bonds should only comprise a modest portion of a portfolio.
If an issuer is liquidated, stakeholders with a higher priority claim to the issuer’s assets have the potential for a greater recovery than those with lower priority. Generally, priority is as follows: (1) secured debt, (2) unsecured debt, (3) unsecured subordinated debt, (4) junior subordinated debt and trust preferred securities, (5) traditional preferred stock, and (6) common stock. Should a company liquidate or become insolvent, there is no assurance that any holders will receive compensation, regardless of priority of claim.
Interest Rate Risk: Occurs as interest rate changes occur. The yield offered on bonds is based upon a collaboration of all associated risks evaluated, coupled with a market determined spread over a similarly traded riskless transaction (historically measured versus a similar maturity Treasury bond). As interest rates fluctuate, the yield on most bonds will be adjusted accordingly. Generally, as interest rates rise, the price of a bond will fall and conversely, as interest rates fall, the price of a bond will rise.
Modified Duration is a measure intended to indicate the approximate percentage change in price that would occur with a 1% change in interest rates. For example, if a bond had a duration of 4, and interest rates moved down 1% (or 100bp), the bond would increase in value approximately 4%. Conversely, if interest rates moved up 1%, the bond would lose approximately 4% in market value. Convexity estimates the impact of interest rate changes on duration. Modified duration and convexity may be used together to approximate price volatility of fixed-income securities. Modified duration does not account for early redemption features, such as calls by the issuer.
Reinvestment Risk: Timing of reinvestment of returning interest or principal can cause an investor’s return to fluctuate. In a falling interest rate environment, an investor will likely benefit from higher coupons and longer maturities as this prevents the need to reinvest into a lower, less favorable interest rate environment. If interest rates are rising, higher coupon and/or short maturities allow an investor to take advantage of rate increases and put their money to work at improving interest rates.
Liquidity Risk: Liquidity is the ability to sell (liquidate) a position. Most fixed income securities maintain an active secondary market and most broker/dealers, including Raymond James, may maintain a secondary market in securities; however, there is no assurance that an active market will be maintained. Price changes and supply and demand will alter the liquidity of a bond. In addition, certain security types trade in larger volumes and/or have greater or less supply and demand, also affecting the liquidity.
Bond Features: Bonds have various features which should be considered when determining the appropriate fit for an investor. This list is not intended to cover all but some of the more common features.
Insurance: Insurance does not guarantee market value or protect against fluctuations in bond prices. The insurer is responsible for making timely payments of principal and interest if the issuer is unable to do so. The value of the insurance depends on the insurer’s financial stability. There is always the risk that the insurer itself could declare bankruptcy or otherwise fail to meet its obligations under the insurance terms. No representation is made as to the insurer's ability to meet its financial commitments. Any guarantees such as direct government, United States Government Sponsored Enterprise, FDIC or any other insurance applies only to the face value of the investment and not to any premium paid nor does it protect the investor from market risk.
Underlying Ratings pertain to the ratings assigned by a ratings agency to the security without regard to credit enhancement or insurance, or assigned to other securities of the same issuer having the same features and security structure but without the benefit of the enhancement or insurance.
Optionality: Optionality refers to special options permitted to either the issuer or the bond holder. A common option is a call feature. The issuer, when outlined by the original bond indenture, is allowed to “call” or retire the bond issue on predetermined date(s) at a predetermined price(s) prior to the stated maturity date. Callable bonds often provide investors higher yields versus non-callable bonds to compensate them for the additional risk associated with a call. An issuer would typically call a bond if rates are lower and it is advantageous to them to reissue new debt at a lower obligation.
A put feature allows the bond holder to “put” (retire) a bond early and retrieve their invested principal prior to the maturity date, subject to limitations. Some bonds have a convertible feature, allowing the holder to convert the bond into stocks of the company.
Redemption provisions such as calls at the issuer's option, tenders, sinking funds or extraordinary redemptions, provide the issuer an option to repay principal prior to maturity and may change the term of the investment which may affect price or yield calculations.
Estate Protection Feature (survivor’s option): Certain bonds include a feature which allows the estate of the beneficial holder to return the bond to the issuer at face (par) value in the event of the beneficial holder’s death, regardless of the price at which the security is trading at that time. If this security has a zero coupon, then it will be redeemed at the accreted value. As certain limitations may apply such as holding periods or annual limitations, please refer to each individual issuer’s prospectus, offering circular or disclosure document. Brokered CDs also generally include an estate protection feature.
Original Issue Discount (OID) securities are issued at a price less than the stated redemption price at maturity. OID may be deemed interest income and may be reportable for tax purposes as it accrues whether or not you receive any interest payments from the issuer during the year. Please consult with your tax advisor regarding specific OID tax treatment.
Purchasing Power Risk is the risk that, over time, inflation will lower the value of the returned principal. This means that an investor will be able to purchase fewer goods and services with the proceeds received at maturity.
Step-up Coupon Securities increase their coupon payments over a period of time according to a predetermined schedule, unless called at the issuer’s option. Coupon adjustments may not reflect changes in interest rates. When investing in a step-rate security, you may be accepting lower yields initially than comparable fixed-rate securities in return for the potential of receiving higher yields over the life of the investment. However, there is a greater likelihood that the issuer will call these bonds when prevailing interest rates are lower than the current coupon. This may affect the yield on the security.
Variable coupons, which when a characteristic feature of certain bonds, are also referred to as "floater" or "adjustable" rate bonds, pay interest at rates which vary over time and are tied specific indices such as Treasuries, LIBOR, inflation index or some other benchmark or combination of indices. Interest payments may fluctuate. Variable rate bonds provide the holder with additional interest income if the underlying rates rise or with reduced interest income if the rate falls.
Zero coupon bonds may have higher price fluctuations since there are no regular interest payments. These are bonds issued at a deep discount. The redemption is for the full face value making up for the lack of periodic interest payments through a lump sum payout at maturity.
Foreign bonds are subject to additional risks, including without limitation, liquidity, currency fluctuations, differing accounting standards, political and economic instability, and differing tax laws.
Brokered Certificates of Deposit (CDs) purchased through a securities broker and held in a brokerage account are considered deposits with the issuing institution and are insured by the Federal Deposit Insurance Corporation (FDIC), an independent agency of the U.S. Government. FDIC deposits are insured up to $250,000 per issuer (including principal and interest) for deposits held in different ownership categories, including single accounts, joint accounts, trust accounts, IRAs, and certain other retirement accounts. The deposit insurance coverage limits refer to the total of all deposits that an account holder has in the same ownership categories at each FDIC-insured institution.
Brokered CDs are redeemable at par upon death of beneficial owner. Only the par (not the premium paid) is FDIC-insured. Each insured institution is assigned an FDIC certificate number which appears on trade confirmations and statements. The FDIC certificate number is important because mergers and acquisitions may lead to the consolidation of multiple institutions under the same certificate number, thereby reducing your insurance coverage if you held deposits at each of the consolidating institutions. 'Certificate of Deposit Disclosure Statement’ is available here or upon request from your financial advisor. Additional information is available from the FDIC at www.fdic.gov/deposit/deposits/index.html and from the Securities and Exchange Commission at sec.gov/investor/pubs/certific.htm.
Corporate Bonds are debt obligations issued by U.S. and foreign companies, most of which represent unsecured promises to repay the principal at a predetermined future date, although some may be secured by a lien on certain corporate assets. In most instances, the issuing company also agrees to pay interest to investors. As bonds are obligations of the issuer to pay back borrowed funds, they generally have priority to pay interest prior to any dividend distributions on the issuer’s stock.
GSE securities are issued by government-sponsored enterprises (GSEs). Payment of principal and interest is the obligation of the issuer. These securities are also known as agency securities. Although they are not guaranteed by the U.S. government, they maintain an implied backing. They are subject to market risk if sold prior to maturity. Ginnie Mae (GNMA) securities are backed by the full faith and credit of the United States Government.
Mortgage-backed securities and Collateralized Mortgage Obligations (CMOs) are priced based on an average life which includes prepayment assumptions that may or may not be met and changes in prepayments may significantly affect yield and average life. The actual maturity date may be shorter than stated. For more information, please review FINRA’s Investor’s Guide to Mortgage Securities and CMOs at finra.org. Mortgage-backed securities are generally regarded as higher yielding investments with relative safety of principal when issued by one of the Government Sponsored Enterprises (GSEs). However, the potential reward of higher yields is dependent on the predictability of timing the return of principal contingent upon the cash flows from the underlying mortgage pools, as homeowners have the option of prepaying their principal at any time.
Tax-Exempt Municipal Bonds are issued by state and local governments as well as other governmental entities to fund projects such as building highways, hospitals, schools, and sewer systems. Interest on these bonds is generally exempt from federal taxation and may also be free of state and local taxes for investors residing in the state and/or locality where the bonds were issued. However, bonds may be subject to federal alternative minimum tax (AMT), and profits and losses on bonds may be subject to capital gains tax treatment. Municipal securities may lose their tax-exempt status if certain legal requirements are not met, or if tax laws change.
Taxable Municipal Bonds are issued by state and local governments as well as other governmental entities to fund redevelopment districts, stadiums, pensions and utilities. Interest or other investment return is included in gross income for federal income tax purposes and may also be subject to state and local income tax. A municipal security may be issued on a taxable basis because the intended use of proceeds does not meet federal tax law requirements for the exclusion from gross income, because certain other federal tax law requirements are not met, or because the issue qualifies for a tax credit or subsidy.
Investors interested in regular updates about individual municipal securities can sign up on EMMA (emma.msrb.org.) to receive e-mail alerts when disclosure documents are posted on the website. Investors who track particular bonds identified by their unique “CUSIP” numbers can receive an e-mail notification from EMMA if a new disclosure document is posted for that security. These documents can include annual and other periodic financial filings, operating data and other types of material events. To sign up for an alert, enter a nine-digit CUSIP number into the “Muni Search” function of EMMA.
For more complete information about new issues, including charges and expenses, obtain a prospectus or municipal official statement from your Financial Advisor. Alternatively you can access this information on sec.gov/edgar.shtml or emma.msrb.org. Please read it carefully before you invest or send money.
Preferred Securities are comparable to fixed income investments as their coupon/dividend payments are generally fixed over the term of the investment and will react similarly to other debt investments to changes in market conditions. Preferred securities present a greater risk because they are generally subordinate to debt in liquidation priority. Preferred securities are quoted on either a current yield basis, or a yield-to-call basis if trading at a premium. For preferred securities that pay dividends, the dividend is paid at the discretion of the board of directors and holders generally do not have voting rights. Preferred dividends may be cumulative or non-cumulative.
Some preferred securities may have a deferred interest feature, which allows the issuer, in certain circumstances, to defer payments between 5 to 10 years or longer depending on the security. The deferred income will generally accumulate, and may be considered as ordinary income for the year in which it is accrued, even though the holder of the security receives no payment until the issuer reinstates interest payments. If deferred, the ability of the issuer to reinstate interest payments is subject to the creditworthiness of the issuer. Changes in income payments may significantly affect yield and final term of the investment and consequently the price may decline significantly. Additionally, preferred securities generally carry no change of control provisions.
U.S. Treasury securities are issued and guaranteed by the U.S. government and, if held to maturity, generally offer a fixed rate of return and guaranteed principal value. U.S. government bonds are guaranteed as to the timely payment of principal and interest; however, these securities are subject to market risk if sold prior to maturity.
This information herein was obtained from sources which we believe reliable, but the accuracy of which cannot be guaranteed. No representation is made that it is accurate or complete, that any returns indicated will be achieved, or that you should rely on it to make an investment decision. Changes to assumptions may materially impact returns. Past performance is not indicative of future results.