While bonds, whether they are corporate bonds, municipal bonds, treasury bonds, or even high-yield bond, are generally considered by most investors to be “safe” investments, they still have elements of risk exposure that investors need to be aware of. It is still somewhat surprising that some people mistakenly believe they cannot lose money investing in bonds, in light of all the information sources available to them. It is important that investors understand that ALL investments have some measure(s) of risk associated with them. Let’s examine some of the risks that investors might unwittingly be exposing themselves to in today’s fixed income environment.
Bonds have traditionally been viewed as safer investments than stocks because they are generally less volatile than stocks in terms of market valuations. But there are risks associated with bonds that can severely impact an investor’s portfolio. Some of the more important risks that investors need to be aware of are Interest Rate Risk, Reinvestment Risk, Credit Risk, and Inflation Risk. Let’s examine each risk individually and some possible strategies to minimize or eliminate that risk.
Interest Rate Risk
Interest Rate Risk is probably the most insidious risk facing bond investors today. Interest rate risk is defined as the risk that the value of a bond investment will change as a result of a change in interest rates. Changes in interest rates inversely affect bond prices. In the low interest rate environment we are presently in, a rise in interest rates will lower the price of existing bonds. How much the price of existing bonds falls depends on a few factors, primarily the change in interest rates and how long before the bonds mature.
To determine the likely decline in the value of a bond, you multiply the change in interest rates by the duration of the bond. The longer the duration of the bond or bond portfolio is, the more precipitous the drop in value of the bond or portfolio will be. Duration is a measure associated very closely with the maturity of the bond. Imagine an investor trying to increase the yield that his or her bond investments produce. So this investor buys individual bonds or a bond mutual fund with longer maturities in order to increase the investor’s yield or return. What is going to happen when the Federal Reserve has to raise interest rates? Let’s say for example that the investor purchased a bond fund that has a duration measure of 20 years because it provides him with a nice yield compared to bonds of shorter maturities. For our example let’s also say that the Federal Reserve is going to raise interest rates a full 1% this summer. In this example, the investor will very likely suffer a 20% loss in the value of his or her bond fund (1% rate increase times 20 year duration = 20% decline in value). Many investors are shocked to learn that bonds can experience that magnitude of volatility, and may be unwittingly setting themselves up for this type of loss. In anticipation of rising interest rates (it is a matter of when, not if), we have shortened up our clients’ bond portfolios to a duration measure of one year or less.
Reinvestment Risk is defined as the risk that future income from a bond will not be reinvested at the prevailing interest rate when the bond was originally purchased. Reinvestment risk is much more likely to occur in a declining interest rate environment. Given the extremely low interest rate environment we are presently in, reinvestment risk is almost non-existent for most investors today.
In addition to minimizing their exposure to Interest rate risk, the bond portfolios we have created for our clients are positioned to take advantage of a rising interest rate environment and have effectively eliminated any Reinvestment risk.
Credit risk is defined as the risk that the borrower will default on the debt by failing to make payments it is obligated to make. Bonds are rated by agencies such as Standard & Poor’s, Moody’s and Fitch will rate bonds on various scales based on the underlying credit-worthiness of a company or government agency. This rating scale is very similar to credit scores for consumers and is used to determine the interest rate, or coupon rate, that bond issuers pay to borrow funds. Similar to consumers, lower rated bond issuers pay higher rates of interest to borrow the funds.
Investors seeking to increase their bond returns may consider lower quality bonds in their portfolio. But there is an increased risk of default for investors the lower the credit quality of the bonds they own. But for some investors, the increased returns may be worth the extra risk, especially given where we have come from during the bear market of 2007 to 2009 with most of the bad credit risks in fixed income may have been flushed from the system.
Inflation Risk, which is also known as purchasing power risk, is the risk that money produced from an investment won’t be worth much in the future because of a decline in purchasing power due to inflation. Inflation risk is one of the few risks that cannot be reduced or eliminated by any investment strategy because it is controlled by the economic environment and is completely out of the investor’s control.
Taming Inflation risk requires earning rates of return on your investments either equal to, or greater than the rate of inflation. And in the low interest rate environment we are currently experiencing, earning a rate of return equal to or greater than inflation requires investing some portion of your portfolio in equities, even though inflation is low by historical standards.
Bonds, or fixed income investments, have an important role in most investors’ portfolios, especially as they get closer to or enter into retirement. But there are risks associated with bonds, just as there are with stocks. But there are ways to minimize, or even avoid risks, with proper planning. Clients of Bollin Wealth Management have immunized their bond portfolios from these risks already.
If you or someone you know isn’t sure about the risks contained in your bond portfolio, give us a call today to set up a free consultation.