One major reason people invest is so they can create a source of passive income. In that particular scenario, having an excellent fixed income is probably your safest bet. However, having this kind of fixed income investment is sometimes not enough. A single source of income, no matter how great, is quite unreliable, due to the fact that the trend can change at any moment, leaving you in a disadvantageous situation. Therefore, it’s important that you diversify your portfolio to provide yourself with some financial insulation. Here are several risks you have to take into consideration and a couple of methods that you can use to protect yourself.
1. Interest Rate Risk
The first problem that you will encounter when trading with bonds are interest rates and this is a scenario that most often happens when one doesn’t buy a bond from the original issuer but does so through a secondary market. These interest rates can go both ways – up and down. In other words, there are scenarios where they’re lower than original interest rates and the scenarios where they’re higher.
Needless to say, bonds that are issued this way are under a much greater risk of being affected by any move on the global market. A decline in interest rate leads to an increase in bond value, while an increase results in the opposite way. For this reason alone, determining bond maturity is also much harder. This is also relevant because holding a bond until its maturity is the most effective way of handling all problems regarding the interest rate.
2. Credit Risk
Those who take a moment to look at a bond from the other side may quickly realize that one of the biggest risks comes from the fact that the original issuer may decide that they can no longer make principal payments. Sure, this is much more common for high-yield bonds, yet it is a possibility that can never really be ruled out. Nonetheless, you need to put your mind at ease, due to the fact that an average ETF comprises many individual bonds and chances that all of these people will simultaneously stop paying are not likely.
According to Scottish trust deed, the safest course of action, in this particular scenario, would be for you to stick to the investment-grade bonds. Like with any other form of investment, the higher the risk, the higher the potential reward. Therefore, balancing between the two is the name of the game.
3. The Risk of a Wrong Call
One of the biggest problems that you could encounter in the field of investment comes from a bad call that you alone get to make. The reason this is so problematic is fairly simple. If the value of the share or bond drops and you sell it, you’re losing the difference between what you’ve invested and the value that you sell it at. This loss also transfers into a loss of potential gain in a scenario where the value of the share bounces back afterward. When selling a stock or a bond, you also have this risk of potential loss, because you really can’t know the full potential of the bond/stock in question.
We can see the best example of how this works through the value fluctuation of cryptocurrencies in 2017. For instance, while a person who sold their Bitcoins at $8,000 made a profit, chances are that they haven’t felt that way a week or two later when the value reached $17,000. A similar thing (although probably not of those proportions) could happen to your stocks, as well. While the trading and income mechanics are not the same, this perfectly illustrates the dilemma that a potential investor would face in a scenario where they sell a bond.
4. Inflation risk
There are a lot of countries in the world where inflation is a serious factor and the fluctuations in the currency’s value might determine the value of your fixed income investment in more than one way. Namely, in this particular scenario, while your investment would remain the same, what it would do is reduce the value of this return. What you would get this way is the reduction in your purchasing power parity, which would make the investment itself a lot less efficient.
5. Diversifying portfolio
One thing we’ve previously discussed is the issue of portfolio diversification. How this works is fairly simple, you keep your investments in as many different formats as possible. Keep in mind that not all these investments have to be fixed income. For instance, you could find an amazing fixed income investment opportunity in the peer-to-peer lending business, especially those who use online platforms to streamline this process. How this works is that you invest in personal loans of others and as they repay you, you get to reap the interest as a profit.
Other than this, you could also consider a non-fixed income investment like commodities (precious metals, diamonds, raw materials, etc.). The bigger the difference is between these two types of investment, the safer your assets will be. This is mostly due to the fact that they act according to different rules of the market. For instance, in moments of crisis (wars, political turmoil, disasters) people lose faith in traditional assets like stocks and currencies. This, however, means that they invest in commodities more.
Aside from this, there are many other investment alternatives that you should consider. Even investing in things like wine or art can be lucrative, provided that you possess an in-depth knowledge of the field or have someone in your contacts to advise you on such a topic.
6. Real estate
Once we’ve got the basics out of the way, it’s important that we briefly reflect on one of the most important alternatives to fixed income investment in bonds. With a passive income, the truth is that most people immediately think about investing in rental property. What they don’t know, however, is the fact that this particular field tends to be riskier than they imagine.
According to Southern California home buyers, the first thing that you need to be aware of is the vacancy rate. This means that while your rental property is vacant, it’s losing you money instead of earning it. Second, it requires quite a bit of management or additional investment. Third, it depends on the location, due to the fact that this will affect the value of the rent, as well as your ability to rent out the place, to begin with. Lastly, if you get bad tenants, you might get a situation that ends up in major losses, property damage and even problems with neighbors. Not to mention irregular payments and worse.
One more thing worth mentioning here is the issue of mortgage-backed securities. This is really a reliable system, however, because it had a large stake in what took place in 2008-9, it’s still something that many people are reluctant to consider.
7. Other ways to lose money on bonds
Finally, it’s important to mention that there are several other ways that you could lose money on bonds. Firstly, in the case of foreign bonds, there is a strict exchange control that may work against you. This could complicate things when it comes to repatriation of funds, which is why most people avoid international bonds, to begin with. Other than this, you have some countries that are taxing these bonds quite severely. Depending on the current regime, you could also face the issue of nationalization, where all your assets in a foreign land get forcibly taken away from you and appropriated by the government for political reasons.
Other types of bonds that can pose risk are municipal bonds. They can lose your money through changes in regulations or, once again, because of the negligence of private issuers. The most interesting thing about municipal bonds is that they’re so appealing because they’re exempt from federal taxation. This means they are only interesting while the tax (that they’re exempt from) is substantial. This can create a unique scenario where a tax decrease actually loses you money.
The very last thing that we need to mention is the fact that fixed income investments aren’t bad, unsafe or unreliable, regardless of how terrifying some of the above-listed issues sound. What matters, however, is that you know of all the risks that are involved in this form of investment so you do not enter this field unprepared. Also, if you are to diversify your investment successfully, you need to know a thing or two about suitable alternatives.