What are the risks of investing in bonds?
Although bonds are considered safer than other asset classes like shares and property, they still come with a variety of risks.
The biggest risk of investing in bonds is that the issuer is unable to continue making interest payments or repay the principal amount that you invested.
This is known as ‘credit risk’ and could occur if a company that has issued corporate bonds goes out of business, for example.
While it is highly unlikely that the Australian government would run out of money and be unable to repay bondholders, it is not impossible.
In the event of a company going out of business, bondholders generally sit ahead of shareholders in the queue to be repaid.
Interest rate risk
Changes in interest rates, such as the official cash rate set by the Reserve Bank of Australia (RBA), can impact the market value of bonds that are listed on a stock exchange like the ASX.
When interest rates go up, the market value of bonds will generally go down, which means you would get less money for them if you chose to sell them before they matured.
If interest rates go down, then the market value of bonds would be likely to rise because the coupon rate on the bond, though unchanged, would become higher on a relative basis.
Liquidity risk
This is the risk that if you decide that you want to sell some bonds you won’t be able to find a buyer for them and you might have to accept a lower price than you want.
Early redemption risk
With some bonds the issuer, a company or government, is entitled to redeem the bonds early. They might choose to do this if interest rates fall and the market price of the bonds goes up, for example.
In this case, the issuer might feel that the coupon on the bonds is too high and buy the bonds back from you at face value.
If you bought the bonds on the secondary market, that could be less than you paid for them.
Inflation risk
This is the risk that the rate of return on a bond fails to match the percentage rise in the cost of goods and services, reflected in the consumer price index (CPI), the main measure of inflation.
If your post-tax returns are lower than the rate of inflation, the value of your investment is falling in real terms.