Ask the Rational Investor: Are Bonds Safe?
Conventional wisdom is that stocks are risky, and bonds are safe.
A share of a company’s stock represents the stock owner’s portion of that individual company. As a result, when sales go up or down, the underlying net income of the company changes too. Over long periods, as a company’s sales and profits grow, the stock price rises to reflect that growth.
Bonds are often considered a safe alternative to stocks. Bonds do not participate in the growth of profits of a business but are simply a loan to the company. All companies will experience changes in their profit, but few companies will default on their debt.
Because investor attitudes towards stocks change quickly, stock prices swing dramatically. Remember, stocks change hands through an auction process, and you can only sell if there is a buyer on the other side of a trade. Buyers and sellers can change their minds quickly as to what price they are willing to pay or receive, as we saw during the unforgettable drop in the spring of 2020 as the pandemic unfolded!
Most investment portfolios consist of a mixture of cash, bonds, and stocks, as the balance between debt and equity helps reduce the volatility in the rate of return in a portfolio.
Investors can select high-quality stocks, such as large mature businesses with strong profits and very little debt. The same can be true for bonds. Each company is awarded a rating determined by an agency that completes an in-depth review of the financials, somewhat similar to what a lender considers when you apply for a mortgage. Bonds are assigned a rating based on the creditworthiness of the borrower which varies from investment grade to high yield, which has a greater likelihood of default.
During the pandemic, the Federal Reserve cut interest rates. As the markets showed signs of healing, more and more investors purchased bonds due to their safety, pushing their prices higher and yields lower.
For investors to get a return similar to the higher, pre-pandemic interest rates, they must decide to take more credit risk (accepting some risk the company might go bankrupt) or take more interest rate risk. Bank certificates of deposit are a great example. If you purchase a CD that matures in five years versus one, the interest rate on the CD that matures in five years will be greater. This risk is called interest rate risk, because as interest rates increase the prices of bonds that mature 10, 20 or even 30 years from now will decline in price to adjust to the current rate.
Many investors have likely neglected this risk. Interest rates have been declining since the 1970s, which has made it easy to take interest rate risk as bond prices kept rising. However, with interest rates almost as low as possible, we think investors should review their fixed-income portfolios and consider the credit and interest rate risk they are taking with longer-maturity bonds. Bonds are generally much safe than stocks, but they do have risks that investors should understand.
Beese Fulmer Private Wealth Management was founded in 1980 and is one of Stark County’s oldest and largest investment management firms. The company serves high-net-worth individuals, families, and non-profits, and has been ranked as one of the largest money managers in Northeast Ohio.