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Knowing All the Risks of Bonds

By: Elite Legacy Education, November 6, 2017

While bonds are seen as safer investment alternative to picking stocks, they don’t come without their own set of risks. Of course, the risks associated with a bond depend on what type of bond it is in the first place. For example, US treasury bonds are considered default-risk-free whereas junk bonds carry high levels of risk.

 

In order to take full advantage of bonds in your trading portfolio, there are six major risks you should be aware of. These apply to both corporate and government bonds:

 

  1. Interest Rate Risk

 

This is perhaps the most prevalent form of risk when it comes to trading bonds. Specifically, there’s an inverse relationship between interest rates and bond prices. When in interest rates decline, bond prices rise and when interest rates grow, bonds prices fall.

 

The reason for this can be understood through the fundamentals of supply and demand. In essence, when interest rates are falling, investors want to lock in the highest rates possible. As such, many people flock to bonds before interest rates drop too low, which drives prices up.

 

On the other hand, if interest rates are rising, investors will ignore low-interest bonds which eventually causes prices to fall.

 

  1. Credit/Default Risk

 

With US treasury bonds, this type of risk is very low since it’s backed by the national government. However, what most investors don’t realize is that corporate bonds do not share this government-backed guarantee. Instead, it’s the company’s sole responsibility to ensure it pays its debts to bondholders.

 

  1. Reinvestment Risk

 

This type of risk refers to the point in time where your bond has been paid back or redeemed, and you are now deciding where to invest your money. In some cases, you may not be able to find another bond with the same level of rates. The potential that rates are lower presents this reinvestment risk.

 

  1. Inflation Risk

 

Inflation is one of those things you can never escape – and the same goes for bonds. Since you’re typically locked in to a set of fixed terms, if inflation rises dramatically, then the purchasing power of your return will decline. One can only hope that inflation stays in check for the duration of their bonds.

 

  1. Rating Downgrades

 

When discussing the difference between investment-grade and junks bonds, it is represented by different quality ratings. Two major bond-rating companies are Moody’s and Standard & Poor. If either of these rating agencies downgrade a bonds rating, it can have dire consequences on the issuing company.

 

  1. Liquidity Risk

 

This refers to your ability to resell any bonds on the market you’ve purchased. It’s said that there’s typically always a market for government bonds. However, the same cannot be said for all types of corporate bonds. So just make sure you know what you’re locking into when you buy a bond.

 

Conclusion

 

Keep in mind, with no risks comes no (or very little) reward. This is seen through the low risk-free rate of treasury bonds compared to riskier ones like junk bonds. Now you can use this list of the 6 biggest factors to weigh your bond options and pick the one that’s best for you.

 

You can level the bond market playing field once you know what the professional traders know. Our Elite Legacy Education instructors will introduce you to the trading strategies that produce potential profit when bond prices are falling, lock in gains, reduce risk, and squeeze extra money out of bonds in your portfolio.

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