Bonds Are Not Always Safe

Many people believe that bonds are risk-free. The common idea is simple: put money in a bond, get your interest, and get your capital back. But this is not always true. It depends on the type of bond you buy. Some bonds can carry a real risk of losing your capital. Junk bonds, for example, can be risky. Even bond index funds, which are generally safer than some individual bonds, can go through long periods of losses.

Bonds Can Stay in Loss for Years

The past 25 to 30 years show that bond investments can remain in a drawdown for a long time. In some cases, the period has lasted from four months to as long as 72 months.

The current drawdown that started around August 2020 has reached about 17% at its worst, and the bond index has gone for around 72 months without making money. This shows why bonds should not simply be called a risk-free asset.

Why Do Bonds Have Risk?

When you buy a bond, you are basically lending your money. You are giving money to a company or another borrower with the expectation that the money will come back with interest. But there is always some risk that the borrower may not be able to pay. This is one reason why corporate bonds and PSU bonds can offer higher returns than a normal bank deposit. The extra return is there because you are taking some extra risk.

Interest Rates Can Hurt Bond Prices

There is another important risk in bonds. When interest rates rise, bond prices usually fall. This can be a big problem for people holding old bonds with very low interest rates. For example, someone holding a bond that pays only 0.5% or 1% may continue to receive that interest, but the market value of the bond can fall sharply when new bonds offer much higher interest rates. So, even if the interest keeps coming, the value of the capital can drop.

Inflation Can Reduce Your Real Return

Getting your capital back does not always mean you made a good return. Inflation and a rising money supply can reduce the real value of your money over time. Imagine holding a bond for 10 years and earning only 1% interest. After 10 years, you may get your capital back along with the interest, but that money may buy much less than it could have bought earlier. This is why looking only at the interest rate is not enough.

Think About Real Returns

Bonds can be safer than many other investments, but safer does not mean risk-free. There can be credit risk, interest rate risk, and the risk that inflation will reduce the value of your money. So, instead of asking only how much interest a bond gives, it is important to ask how much real return you are actually getting after considering inflation and changes in bond prices. Bonds can have a place in a portfolio, but they should not be treated as completely risk-free investments.