Relationship Between Bond Prices and Interest Rates
The inverse relationship between bond prices and market interest rates is a core risk in fixed income investments. For example, in 2021, the yield on the 10-year U.S. Treasury rose from 0.93% at the start of the year to 1.74% in March, causing bond prices to drop sharply. According to Bloomberg, the long-term government bond index dropped by more than 14% in the first quarter of 2021, showing that investors suffered losses as interest rates rose. If investors sell bonds during a price decline, they will face actual financial losses.
Different bonds have different sensitivity to interest rates, often referred to as “duration.” Bonds with longer durations are more sensitive to interest rate changes. A bond with a duration of 10 years would see its price drop by about 10% for every 1% rise in interest rates. In 2022, aggressive Federal Reserve rate hikes led to declines in the prices of many long-duration bonds, directly impacting returns for many fixed income investors.
Credit Risk and Default Risk
Credit risk refers to the risk that the bond issuer will not pay interest or return principal on time. Historical data shows that high-yield bonds, also known as junk bonds, typically have higher default rates. According to a report by S&P, the global default rate for junk bonds was 6.3% in 2020, and during the 2008 financial crisis, this rate surged to 10%. This means that investors who purchase junk bonds face a higher risk of losing principal.
Even higher-rated corporate bonds are not without risk. During the economic recession caused by the pandemic in 2020, many AAA-rated corporate bond issuers, such as some U.S. airlines and energy companies, faced bankruptcy risks. Although most companies survived thanks to government aid and market financing, investors still faced uncertainty and potential losses.
The Impact of Inflation
Inflation significantly erodes the real returns of fixed income investments. In 2022, inflation in the U.S. reached a 40-year high, exceeding 8% annually. That same year, many bonds had nominal yields in the 2%-4% range, meaning real yields were negative. Investors holding 10-year Treasury bonds, with a nominal yield of about 3%, saw their purchasing power decline by 5% due to the 8% inflation rate.
Some inflation-protected bonds, like U.S. TIPS, offer returns linked to inflation, but their yields tend to be lower. Additionally, when inflation subsides, the actual returns on these bonds may fall below expectations. Even when using inflation-hedged instruments, investors still need to weigh the balance between returns and risks.
Liquidity Risk and Early Redemption
Liquidity risk also significantly affects the value of fixed income investments. In the secondary market, smaller or lower-rated corporate bonds often face liquidity shortages, making it difficult for investors to sell them at reasonable prices when needed. According to Moody’s, liquidity in the junk bond market worsened significantly during economic downturns. At the start of the pandemic in 2020, liquidity in many high-yield bonds was severely constrained, leading to substantial price drops, and investors were unable to sell in time, resulting in losses.
