Fixed-income investing can be an attractive way of adding diversification and income to an investor’s portfolio. Fixed-income investments provide investors with dependable, consistent sources of income and can offer stability compared to more volatile investments such as stocks. Many investors, especially those approaching retirement, use the fixed-income asset class to provide them with the income they need for life. Nonetheless, fixed-income investing carries some risks, and investors need to be aware of these potential pitfalls before entering this arena.
Measuring Risk
Before diving into the biggest risks associated with fixed-income investing, it’s important first to understand what risk actually means. Risk is simply the measure of the probability that an investment will lose or gain value due to unforeseen circumstances, or market conditions. An investor must understand the risk they are willing to take and match it to the investments they are looking to make.
Interest Rate Risk
One of the biggest risks of fixed-income investing is interest rate risk. Interest rate risk is the risk associated with long-term fixed-income investments. This type of risk is that the value of an investment will diminish as interest rates rise and bond values diminish. When a bond is held to maturity and all payments are made as described, the value of a bond matures at it’s original value. Therefore, when interest rates rise, the value of the bond in the secondary market will begin to diminish as newly issued bonds are available for higher interest rates. This can pose a risk for investors, as their fixed-income investments can lose their value in the secondary market.
Inflation Risk
In addition to interest rate risk, another major risk of fixed-income investing is the risk of inflation. Inflation is the increase in the price of goods over time due to a rise in the cost of labor or materials. Fixed-income investments such as bonds and GICs often have a fixed rate of return, meaning that the rate of return is not adjusted for inflation. This can cause an investor to lose purchasing power over time, as the returns earned on the fixed-income investments may be worth less in the future when inflation is taken into account.
Credit Risk
Credit risk is another major risk associated with fixed-income investing. Credit risk refers to the risk associated with the issuer of the fixed-income security. As the issuer of the security pays out the promised returns, if the issuer defaults on the payments, the investor is at risk of not receiving the payments as promised. Credit risk can vary greatly depending on the issuer of the security, so it’s important for investors to research and understand the potential credit risk associated with their investments.
Default Risk
Similar to credit risk, default risk is the risk associated when an issuer of a fixed-income security fails to make payments as promised. Default risk is often very closely related to credit risk, as it is usually only when a issuer fails to make payments as promised will they default on the agreement.
Liquidity Risk
Unlike stocks and other more liquid investments, fixed-income investments such as bonds can often be difficult to liquidate or sell off. This is known as liquidity risk and can pose a problem for investors who may need to access the capital quickly. Investors should always consider the potential liquidity risk of a fixed-income investment before investing in it to ensure that they will be able to access the capital when needed.
Reinvestment Risk
Another type of risk associated with fixed-income investing that investors should be aware of is reinvestment risk. This is the risk that investors will not be able to reinvest their repayments back into the fixed-income investment or into a security of similar risk and return. If investors are not able to reinvest the money they receive back into the same or a similar security, they could be at risk of receiving a lower return than originally anticipated.
Fixed-income investing can be a great way to diversify an investment portfolio and earn consistent, reliable returns. However, it’s important to understand the risks involved before investing in these types of securities. Interest rate risk, inflation risk, credit risk, default risk, liquidity risk, and reinvestment risk are all potential risks associated with fixed-income investing. By understanding these risks and taking the time to research potential investments, investors can make informed decisions and avoid potential losses.
