Major Risks Associated with Fixed-Income Investments

Key Takeaways

• Buying bonds can minimize risk in a bear market.

• There are alternatives to bonds, which can be safer than stocks but still carry risks.

• Creating a portfolio that mixes asset classes has the potential to minimize risk while generating consistent returns.

Investors use a variety of strategies to minimize risk during times of economic hardship. While some seek to diversify their portfolios with assets not directly tied to public markets, others seek to preserve their capital and income through bond investments.

Bonds are fixed-income investments that can provide a steady income stream and are typically less risky than stocks. That is not to say that bonds are completely safe, however. All investments carry some degree of risk and there are some distinct concerns associated with bonds.

This article focuses on risks that are unique to bonds, as well as alternatives to such investments.

What are Bonds?

Unlike stocks, which are shares in companies, bonds are essentially loans to governments or corporations by investors. In exchange, the issuers pledge to repay the original investments by a certain date, in addition to interest at regular intervals, typically semi-annually.

Why Buy Bonds?

During bear markets, some investors seek protection from stock volatility with bond purchases. Bonds have the potential for providing regular income, typically at higher interest rates than money market investments.

Risks Unique to Bonds

While no investment is exempt from risk, some risks are exclusive to bonds. These include:

Credit Risk

The risk here is the bond issuer will go bankrupt and default on at least one payment before the bond becomes mature. Should a default occur, the investor risks losing income to which they were entitled, plus their original investment.

Corporate bonds are not guaranteed by the U.S. government’s “full faith and credit,” but instead rely upon the issuer’s debt repayment ability.

To help investors gauge credit risk, independent entities such as Standard & Poor’s, Fitch, and Moody’s provide ratings based on their appraisal of the issuer’s credit worthiness.

Interest Rate Risk

Bond prices could fall as interest rates rise. When that happens, new bonds are likely to be issued with higher yields, rendering the old or outstanding bonds less appealing.

Market Risk

The risk of bond price fluctuation (market risk) can result in the inability of an investor to hold the bonds until maturity. The investor risks losing a portion of their investment, plus the future income stream If that occurs and the bond’s price has fallen.

Other Bond Risks to Consider

The risk of investing in bonds also include:

• Liquidity risk. A thin market with few bond buyers and sellers could render an investor unable to quickly sell their corporate bonds, which could force them to take a much lower price than expected.
• Call risk. This refers to the possibility that the bond’s issuer will cut short its term if interest rates drop.

How Bonds Pay Interest

Bond purchasers commit to receiving a fixed rate of return for an established period. If the market rate rises from the date the bond was bought, its price will drop commensurately. If the bond is sold in the secondary market, it will subsequently trade at a discount. This is a reflection of the diminished return the purchaser will make on the bond.

Zero-coupon bonds do not pay interest. Instead, they trade at a steep discount, producing a profit at maturity when the bonds are redeemed for their entire face value.

FAQs About Bonds

Alternatives to Bonds

Smart investors look for ways to further diversify their portfolios, particularly during times of market volatility. A good way to produce consistent returns may be through holding mixed asset classes.

There are options besides bonds. The alternative investment platform Yieldstreet, for example, has offerings that can serve to diversify investor holdings. Its structured notes program, for example, leverages the benefits that derive from equity, but in a structure that is closer to that of a bond.

Experienced investors and financial experts advise creating portfolios that are not wholly moored to the ups and downs of the stock market. Alternative investments can be a good way to help accomplish this.

Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened several carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Bonds have the potential to generate sound, consistent income. However, there are pitfalls associated with this type of investment to consider. In seeking to protect portfolios from unstable public markets, investors might also want to consider alternative investments, which as a class are becoming increasingly popular.

All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.