Sure, bonds can be a safe investment if you buy one, retain it for its entire term, receive a decent interest income, and the borrower manages to avoid defaulting. Yet, this scenario is riddled with potential hazards. In the current climate, these precarious situations can lead to liquidity issues, delayed payments, or even a default. Two primary risks abound in the current bond market: credit risk and interest rate risk.
Let’s dig deeper into these risks:
1. Credit Risk: Essentially, higher interest rates represent higher risks. If the general range is 3% and you’re offered 8%, it’s crucial to scrutinize the income, debt, and future prospects of the borrower. As observed by Ted Hampton of Moody’s Investor Service, unfunded pension liabilities are becoming problematic and even unmanageable, given the example of Illinois.
So what happens at worst? Bankruptcy or default, as seen previously with Chrysler, General Motors, Delta Airlines, U.S. Air, United Airlines, and cities like New York (1975), Cleveland (1978) and Orange County, California (1994). Bondholders usually negotiate settlements in bankruptcy court, often receiving far less than owed and far later than promised.
The second-worst scenario involves illiquidity. Here, if a state like Illinois frequently issues bonds, it must raise its interest rate to attract new lenders, undermining the appeal of your 3% bond. Holding onto it until term-end and hoping the body doesn’t default is one option, but if you must hasten to sell during an emergency, it might lead to liquefaction at a meagre rate, if you can even find a buyer.
2. Interest Rate Risk: Rising interest rates typically translate to a decrease in your bond’s value. With interest rates in the U.S. at a record low, lower than inflation, they’re bound to rise eventually. Nations like Canada, China, and the European Union have already begun hiking interest rates. This forces high-risk bond issuers to raise rates to attract new borrowers in alignment with credit risk.
In the current times of hiking interest rates and high debt levels of nations and firms, your bonds’ market value may drop. There might even be fewer takers if you wish to sell them. States can’t declare bankruptcy, but they can default on their bonds.
Key parameters can guide your bond portfolio’s financial fitness. These include fiscal health, yield rate, indebtedness of Municipal Bonds, the longevity of corporations, the source of the revenue of the Revenue Bonds, and the reach of your funds across multiple factions. Remember, even seemingly safe bond funds can falter when the whole industry faces a downfall.
Take heed of credit and interest rate risks in today’s bond market. When deliberating over your bonds, focus on the shorter term, higher credit-worthiness ones and scrutinize your portfolio with diligence.
