Bonds are often described as safer than stocks. That description can become dangerously incomplete. A high-quality government bond may have extremely low default risk while still losing significant market value before maturity. The reason is interest-rate risk.
Start with a simple bond
Suppose you buy a bond paying 3 percent interest.
Soon afterward, newly issued bonds with similar credit quality and maturity begin offering 5 percent.
Your 3 percent bond is now less attractive.
An investor choosing between your older bond and a brand-new 5 percent bond would have little reason to pay full face value for yours.
Its market price therefore falls until the expected return becomes competitive with current market rates.
This creates one of the most important relationships in fixed-income investing: when market interest rates rise, prices of existing fixed-rate bonds generally fall. When market rates fall, existing higher-paying bonds can become more valuable.
Investor.gov identifies interest-rate risk as a central risk even for high-quality bonds.
Maturity changes the sensitivity
Imagine two otherwise similar bonds.
One matures next year.
The other matures twenty years from now.
If interest rates rise, the twenty-year bond generally experiences a larger price change.
The short bond will return principal relatively soon, allowing the investor to reinvest at current rates.
The long bond locks in its older coupon for much longer.
Investor.gov notes that longer maturities generally create greater interest-rate risk.
Duration makes that idea measurable
Duration is a bond-market measure used to estimate sensitivity to interest-rate changes.
A simplified interpretation is that a bond or bond fund with greater duration will usually experience a larger percentage price change when market yields move.
For example, a portfolio with a duration near eight years might be expected to lose roughly 8 percent in value if relevant interest rates rose by about one percentage point, assuming other factors remained approximately constant.
That is an approximation.
Real bond pricing is more complicated because of convexity, changing yield curves, credit spreads, and cash-flow structures.
Still, duration provides a useful mental model.
Longer-duration assets generally react more strongly to rate movements.
Holding an individual bond to maturity changes the experience
Suppose you buy a high-quality bond and its market price falls from $1,000 to $920.
If you must sell immediately, the decline matters.
If the issuer remains able to pay and you hold the bond until maturity, you can generally continue receiving the promised coupon and eventually receive face value according to the bond's terms.
The temporary market-price loss may therefore have little practical effect on an investor who never needs to sell.
The risk is different for someone whose financial goal arrives before the bond matures.
Liquidity needs transform paper volatility into real financial risk.
Bond funds behave differently
A bond mutual fund or ETF continually holds portfolios of bonds.
The fund does not have one single maturity date on which the investor is guaranteed to receive a fixed face value.
Its net asset value changes with the market value of the bonds it owns.
Investor.gov specifically warns that bond funds remain exposed to interest-rate risk and that funds holding longer-maturity bonds generally face greater sensitivity.
This is why owning bonds provides very little information about actual risk.
A short-term Treasury fund and a long-duration corporate bond fund may behave very differently during a rate shock.
Credit risk is separate
Interest-rate risk should also be distinguished from default risk.
U.S. Treasury securities and low-rated corporate bonds can both decline when interest rates rise.
The corporate bond adds another problem: the company itself might become less able to repay its debt.
Investors often receive higher yields for taking greater credit risk.
A large yield can therefore be compensation for danger rather than free additional return.
Safety always needs a definition
A financial asset can be safe in one dimension and risky in another.
A long-term Treasury has very strong credit backing. Its market price can still fluctuate substantially.
Cash has almost no nominal price volatility. Inflation can reduce its purchasing power.
Stocks can be extremely volatile over short periods while historically offering substantial long-term growth potential.
Is it safe? is therefore incomplete.
A better question is: safe from what?
Sources
- SEC Investor.gov, bond risks.
- SEC Investor.gov, corporate bond interest-rate and liquidity risk.