Are Bonds Risk-Free Investments? Managing Default Risk in Your Bond Portfolio

After the stock market crash in 2008, many investors decided that they don’t want to take on risk by investing in the stock market. Instead, they have moved their investments to bonds, which they believe are risk-free. However, if we take a closer look at bonds, we will find that they contain their own significant sources of risk. Knowing how to manage this risk is the key to successful investing in bonds. In this article, we discuss default risk, which is the risk that the issuer of the bond will at some point not be able to pay the interest and/or principal due on the bond.
With regard to the bonds of major governments, such as the U.S. and the U.K, this risk is currently assumed to be minimal (although that could change over time if government finances worsen significantly). Corporate bonds, however, are another story. How do you assess the default risk of a corporate bond? The default risk of a corporate bond is generally a function of the company’s credit rating. Higher rated corporate bonds have a relatively small risk of default, as these are companies with a strong financial position. Lower rated companies, on the other hand, can default on a regular basis. The highest rating is “AAA”, followed by “AA”, “A” and “BBB”. Bonds rated below “BBB” are referred to as high yield bonds, and are issued by the lowest quality companies, which are prone to default. Of course, those companies pay the highest interest rates in order to compensate for the risk of default, hence the name high yield bonds.
It’s important to find out what kind of companies you are invested in so that you can assess whether you are comfortable with the level of risk in your portfolio. If you are invested in a bond fund, the material you receive from the fund on a quarterly basis should provide a breakdown of the percentage of the portfolio by credit rating. A modest allocation to high yield bonds should not drastically alter the risk of your portfolio. However, if your portfolio is dominated by high yield bonds, you may want to consider whether you are comfortable assuming so much risk. The percentage of lower quality companies that are defaulting is currently low, but it could rise if the economy takes a turn for the worse.
Being educated about the level of default risk in your bond portfolio will help you to be a smart and successful bond investor.