What are the risks of bonds?
As an investor, you are of course always looking for a form of investment that gives a high return, but which is also safe. An example of a relatively safe investment is the bond. For a long time, many investors thought investing in government bonds was a safe haven. But do bonds and government bonds in particular have such a low risk?
What are the risks of bonds?
If the issuer of the bond is unable to repay the loan, then as a bondholder you have a problem. Even governments are not 100% infallible. As the owner of a bond, you therefore run the risk of losing your deposit. However, this risk is usually lower than for investments in shares.
Another risk of investing in bonds, is the fact that prices may change. This is especially important if you intend to buy and sell the bonds in the interim. After all, at the end of the term you get the nominal value back, regardless of the exact price.
You run a currency risk when you buy a bond in another currency. This is the case when you buy a bond noted in dollars for pounds. When the dollar falls in value, your interest payments in pounds decrease. The currency risk can therefore reduce your return.
Assessing the risk of a bond
You can often assess the risk of a bond by looking at its rating. A rating indicates how risky a bond is. A good rating indicates that the creditworthiness of a country or company is good and that you will probably get your money back. Bonds with a poorer rating often have a higher interest rate. After all, interest is the compensation for the risk you run!
What is a government bond?
A government bond is also referred to as a government loan. It is a bond issued by a government. In most countries government bonds are marketed by the Ministry of Finance. This agency attracts long-term and short-term loans to cover the government’s financing deficit.
Most government bonds have a term of ten years. However, there are also government bonds with shorter or longer maturities.
Return on government bonds
In recent years, real yields on many government bonds have become negative. Interest rates have fallen sharply. Interest usually compensates for the risk you run. Governments are seen as more stable than companies, which means that the interest rate is considerably lower. As a result, interest rates have fallen sharply under the influence of rising stock markets and low risks on government bonds.
When other investments yield less, the prices of bonds and government bonds rise again. During uncertain economic times, you can expect higher interest rates, as the risks are higher. Nevertheless, it is clear that other investment classes have become more popular compared to government bonds.
The end of the euro
Government bonds are not always a safe haven. This was already apparent in the debt crisis in which various European governments threatened to be unable to repay their debts.
Some economists philosophize about what will happen to the euro now that some European countries have been hit harder by the recession than others. This may lead to the temptation to return to their own currencies.
The turmoil in this period caused government bond yields to rise sharply. After all, the risks of government bonds increased considerably! Governments threatened to go bankrupt or were, in fact, already bankrupt: as a result, the prices of government bonds fell and the risk of bankruptcy for an entire government became increasingly realistic.
Are government bonds really that safe?
As we have seen in the past, there does appear to be a crack in the supposed safety of government bonds. Nevertheless, government bonds are still considerably safer compared to shares and corporate bonds. Periods of rise and fall alternate regularly in the financial world.
Long-term government bonds
Long-term government bonds in particular are risky if the financial climate becomes healthier. The current interest rate is in many cases so low, that the return to be achieved becomes negative when inflation increases. It is therefore risky to opt for long-term government bonds.
Short-term government bonds are therefore often the preferred choice for investors looking for a safe investment haven. Moreover, it is important to keep a close eye on the risk-measuring indicators on the stock market. As soon as the stock markets improve, the profitability of bonds often decreases.