Are Bonds “Safe” Even If They Drop In Value?

“Are bonds safe?” asked a fellow in a café who recognized me from the Friday paper. We then lamented having to pay 16 NIS instead of NIS 15 for our coffee. “Inflation,” I commented. Then he asked for advice about bonds: “If the central bank raises interest rates to control inflation (rising prices), bond values could fall, so should I sell the bonds in my retirement portfolio now?”

Here are some specific risks you will be exposed to when you hold bonds in your portfolio:

CREDIT RISK

When you buy a bond, you lend money to a government or company. In exchange, they pay you interest for the time they hold the funds. U.S. government bonds are considered to be among the most creditworthy, which is why global investors often buy Treasuries in times of financial crisis. Corporate bonds normally have a higher chance of default than Treasuries, but they also pay a higher interest rate.

INTEREST RATE RISK

When you buy a bond, you lock in a specific yield. If interest rates then rise, you’re still holding on to a bond that has a lower rate. Your bond will be less attractive in the marketplace and will go down in value.

INFLATION RISK

What happens in the real market, such as your local coffee shop, is often the best evidence of whether economic growth is picking up. The reason that inflation causes the prices of bonds to decrease is because people know that when those bonds mature, the future value of the dollars won’t buy as many goods and services as they do today. If the money will be worthless in the future, the bond will also go down in value today.

DIVERSIFICATION VALUE RISING

Regardless of these risks, bonds as part of a diversified portfolio offer the benefit of spreading out risk.