I often speak with clients, prospects or friends, that tell me that bonds are risk free. This does not pertain just to novel investors, but experienced and knowledgeable investors as well. Apparently, it is not just my circle that believes this. Last month, Blackrock conducted a survey that reveals that most investors are uninformed in the area of bonds, or fixed income.
44% of investors that consider themselves knowledgeable believe that you can’t lose money when it comes to bonds. The truth is that bonds or fixed income are most certainly not risk free. They can be less volatile than stocks, but this does not mean that they don’t hold a risk. There are a number of risks when it comes to bonds. The first risk is credit quality. Bonds are simply loans that a company, municipality or a government pays back to an investor with interest. If that company, municipality or government cannot pay back the loan, the risk does fall on the investor. The second risk is duration risk, which means how much the bond will be affected by rising interest rates.
Another myth that knowledgeable investors believe is that rising interest rates are good for bond prices. 37% of those surveyed said rising interest rates are good for bond prices, while 27% said that a rise in interest rates should make no difference on bond prices. The fact is that bonds are often negatively affected by rising interest rates, with the exception of negative or low duration bonds. Most bonds tend to go down when interest rates go up. The reason bond prices tend to go down when interest rates go up is because if a bond exists at a certain rate, and then rates go up, it actually gives new bond issuers higher interest rates, which makes the existing bond less valuable.
One item that most of the participants seem to have gotten right is the prospect of rising interest rates in the next year, with 65% of participants confident that interest rates will rise this year. Janet Yellen, the chair of the US Federal Reserve System has repeatedly remarked that the Fed plans to continue to raise interest rates this year. With this coming up, it is important that investors plan accordingly.
“Many Americans appear to lack sound basic knowledge about fixed income investing and the role fixed income plays in their portfolio,” said Jeffrey Rosenberg, BlackRock’s Chief Fixed Income Strategist. “They need to be aware of some hidden risks. After years of declining and relatively low interest rates, the prospect of rising rates represents a sea change for investing, yet many Americans don’t understand what this change could mean for investing strategies.”
In order for investors to properly adjust and diversify a portfolio against rising interest rates and a changing environment, it is important for investors to conduct their own research and consult a trusted financial advisor.
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