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I think bonds are debt/loan and fixed-income, so they are risk-free, both short term and long term. But it seems like Bodie's Investment thinks long-term bonds are risky:

For example, assume that the total market value of an initial portfolio is $300,000, of which $90,000 is invested in the Ready Asset money market fund, a risk-free asset for practical purposes. The remaining $210,000 is invested in risky securities--$113,400 in equities (E) and $96,600 in long-term bonds (B). The equities and long bond holdings comprise "the" risky portfolio, 54% in E and 46% in B.

Why are long-term bonds risky?

Are short-term bonds risky or riskless? Thanks!

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5 Answers

up vote 7 down vote accepted

Bonds have multiple points of risk:

  1. Default (which, with the Greek crisis can't be ignored for sovereign debt or corporate)
  2. Inflation - how much is the money you get at maturity actually worth?
  3. Interest rate movement - A long term bond paying say 2%/yr and $1000 in 30 years will trade for far less than $1000 if rates rose to 10%, $245.85 to be exact. That's quite a loss. Rates don't change so fast, but even a rise to 4% reduce the present value to $654.16.

This is part of the time value of money chapter in any finance course.

Disclaimer - Duff's answer popped up as I was still doing the bond calculations. Similar to mine but less nerdy.

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I'm glad you calculated it... it's a great illustration that even if a bond is nearly risk-free from a default POV, rate risk is real! –  duffbeer703 Sep 23 '11 at 1:17
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In the quoted passage, the bonds are "risky" because you CAN lose money. Money markets can be insured by the FDIC, and thus are without risk in many instances.

In general, there are a few categories of risks that affect bonds. These include:

  1. Interest Rate risk (Rising rates lower the values of existing bonds)
  2. Default risk (The creditor will stop repayment)
  3. Downgrade risk (If a bond rating is downgraded, it will become less valuable)
  4. Liquidity (Will a market exist for a bond?)

The most obvious general risk with long-term bonds versus short-term bonds today is that rates are historically low.

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Even very short-term fixed income securities can be risky. You said "Money markets can be insured by the FDIC." Actually, money market funds are NOT insured by the FDIC. Their objective is to provide risk-free returns, but recall the expression "breaking the buck"? There are historical instances of money market funds experiencing losses due to externalities, and as a result, the Net Asset Value (NAV) actually did fall below $1.00. –  Feral Oink Oct 8 '11 at 17:47
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AAA bonds are safe, as far as the principal goes. If you buy long term bonds today (at very low rates) and the interest rate goes up to 10% in 5 years, the current value of the bonds will decrease. But if you hold the bonds till maturity, you will almost certainly (barring MBS scenarios) get the expected principal and interest on the bonds.

If you decide to sell a long-term bond before it matures, it will probably be worth less than you paid for it if interest rates have risen since you bought it.

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AAA bonds are supposed to be safe. :) but even then, who says the dollars you get back are going to be worth as much as they are now? –  fennec Oct 12 '11 at 0:59
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In truth there is no such thing as a risk-free asset. That is why your textbook feels the need to add the qualifier "for practical purposes," meaning that the risk of a money market account is so much lower than virtually any other asset class that it can reasonably be approximated as risk free.

The main risk of any bond, short-term or long-term, is that its price may change before the maturity date. This could happen for one of many reasons, such as interest rate changes, creditworthiness, market risk tolerance, and so on. Thus you may lose money if you need to redeem your investment ahead of the scheduled maturity.

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Long-term bonds -- any bonds, really -- can be risky for two main reasons: return on principal, or return of principal. The former is a problem if interest rates are low (which they are now in the US) because existing bonds will fall in price if interest rates rise. The second is a problem if the lender defaults: IOU nothing.

No investment is riskless. Short-term bonds command a lower interest rate than long-term bonds (usually) because of their quicker maturity, but short-term bonds carry risk just like long-term bonds (though the interest rate risk is lower, sometimes quite a bit lower, than for long-term bonds).

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MB - but the interest rate risk is far more dramatic as the maturity goes out. I tried to illustrate that for Tim, but of course it's not intuitive, and my example probably impresses people who already understand the nature of bond pricing. –  JoeTaxpayer Sep 23 '11 at 13:43
    
@JoeTaxpayer: Good point. I tried to add that to my answer. –  mbhunter Sep 23 '11 at 14:16
    
mb - looks good. I am considering asking and answering "can someone explain in simple terms how bonds change in value as interest rates change?" –  JoeTaxpayer Sep 23 '11 at 16:02
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