Image credit: epSos.de
Simplified lists that order investments by risk almost universally describe bond funds as less risky than equity funds, and often, this is true. But it isn’t categorically true, and that’s a problem for me. A novice may think he or she has enough information to reasonably conclude that any bond fund will provide the stability to offset any losses from riskier investments. This is because in our effort to simplify things, we sometimes leave out important information.
Critical differences
Equity fund managers invest your money in securities that represent ownership. Most commonly, these are stocks, but there are other types of equity securities.
The risks of equity funds are those related to the price of the securities owned by the fund. Low earnings, market perception and high amounts of corporate debt are some of the many factors that may affect price.
Bond fund managers invest in debt securities, which basically means they loan money. Companies and governments issue bonds to raise capital, and investors (such as fund managers) buy those bonds, in effect lending money to the entity that issued the bond at an agreed-upon interest rate.
The most common risks of bond funds generally fall into two categories: the possibility that interest rates will rise while your money is tied up, and the likelihood that the debt will be repaid. A third risk category would be currency risk, which applies to any security from a foreign country.
Consider what those last two risk categories mean. As the likelihood that a debt will be repaid decreases, another one rears its head: the likelihood of default. Default, as you might imagine, can result in the near-total loss of an investment, and that is a pretty big risk. Also significant is currency risk, since the money will be loaned in the currency of the country where the bond is issued. If an investor is being repaid in currency that declined significantly relative to the dollar after the investment was made, the value of the investment could decline dramatically.
The bottom line
Some bond investments carry more risk than many equities. Bond issuers are graded by creditworthiness. Higher grade, shorter duration domestic bonds are generally safer, so if you’re looking to mitigate riskier investments in other areas of your portfolio, start there.