Many investors put their money into bonds for the safety and predictability of income. Now, more than ever, it is a good time to visit the risks that are associated with bonds but rarely discussed.
A major concern with any type of bond is the default risk. This is the likelihood that the issuer, usually a local government or a major corporation, will fail to live up to its obligation. Along with the default risk, is the market is concerned that the issuer may default, the bond's price is likely to suffer as the market adjusts for a potential default.
Municipal bonds are issued by local governments to generate revenue that is used to finance local and state governmental spending. Even though these bonds offer a low rate of return, investors have traditionally chosen them for safety that they offer, along with the tax exempt status. The problem that we are facing today is that states are not the only ones facing a budget crisis - many cities and counties are on the verge of bankruptcy. This has the potential to sink the entire municipal bond market if defaults do indeed begin to occur.
A problem that refuses to go away is the housing crisis. Municipalities rely heavily on property taxes for revenue. Assessments continue to fall, which reduces the property taxes and reduces the amount of revenue for municipalities. Industry observers have noted that many big cities are at risk of going bankrupt in 2011.
In addition to the default risk, bonds also carry significant inflation risk. Should inflation pick up steam again and head higher, the interest payments as well as the principal will be less valuable. In addition, bond prices traditionally fall when interest rates rise, and interest rates tend to move higher when inflation rates move higher.
Another risk to take into consideration with bonds is something labeled "call risk." Call risk only pertains to bonds that have a callable feature. In this situation, it is the issuer's discretion to purchase the bond back from the bondholder. This is typically done when interest rates are substantially lower than when the bond was originally issued. The issuer retires the bond with the higher interest rate, and reissues a bond with the lower interest rate, thereby reducing the cost of debt. While this is a good scenario for the issuer, it can wreak havoc on planning out an income stream for the investor.
For alternative strategies to provide income while maximizing risk, call us at Family Focus Financial Group at (732) 364-5462.
Tom
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