As Will Rogers once said, "Why not go out on a limb? That’s where the fruit is." In the investment environment his remark translates to, “no risk, no return.” For decades investors have been told that bonds are the safest investment, and perhaps rightly so. For the past 30 years interest rates have continually declined. The interest rate on the 10-year U.S. Treasury bond has averaged 6.6% and many investors believed that their bond principal was pretty risk-free. Fast forward to April 11, 2013, when the interest rate on the 10-year bond had fallen to 1.82%. Will bond rates fall to zero, or will interest rates rise? Both outcomes carry a measure of risk because when interest rates rise the value of outstanding bonds falls, putting your bond principal at risk.
So, bonds do in fact carry some level of risk. Further, bond managers take a series of measures to enhance investment returns, which can increase your risk profile in ways that you might not fully understand. I am not suggesting that you abandon bonds; I am suggesting that you learn about the risks that you embrace when you invest in bonds. Having this type of transparency in your bond portfolio will help you fully to understand your exposure to risk and to evaluate your risk tolerance for your principal.
Here are some basic considerations that will help you assess the amount of risk in your bond portfolio and your risk tolerance for your principal:
- Length Matters
Bond managers talk about two dynamics: 1) maturity, the length of time it takes for your bonds to mature and for you to get your principal back, and 2) duration, a more subtle measure of maturity, accounts for the timing and size of your bonds' coupon (or interest) payments. While duration is a better measure of risk than maturity, it is more complicated and maturity is okay for today’s discussion.
Generally speaking, the longer the maturity of a bond, the higher its coupon (or interest) payments will be. Further, the longer the maturity (or duration) of a bond the more profoundly its value will be impacted by changes in interest rates. For example, in a falling interest rate environment your long-term bonds' interest payments will remain relatively high and the value of your bonds will increase. However, when interest rates rise, the value of your long-term bonds' interest payments will be lower than newer bonds,and the principal value of your long-term bonds will decrease.
- Hanging Out In Short-Term Bonds May Not Help
So if long-term bonds are at risk in a potentially rising interest rate environment, why not keep it simple and hang out in short-term bonds? Well, there is a good reason that such an approach is not gratifying. As I mentioned earlier, 'no risk no return.' Super short-term high quality bonds offer almost no yield. As of April 10, 2013, the one-year U.S. Treasury yield was 0.13% (or about 1/10th of 1% a year). The point is, the U.S. Federal Reserve Board’s policies are designed to make high quality short-term bonds as unattractive as possible so that investors will buy higher yielding long-term bonds, or ideally invest in equities or other assets.
- Transparency Counts
Now we get to the fine print. You may think that you know how long-term your bonds actually are, but there is always the fine print. In the caveats there may be language about "assumed prepayments" (which typically refers to mortgage-backed bonds). Prepayments tend to shorten the term of a bond portfolio when interest rates fall. Or perhaps there is some language about the "call-adjusted duration," which also tends to shorten the term of a bond portfolio when interest rates fall. However, in a rising interest rate environment (which could be on the horizon),there will be less predictable prepayments and calls, which may lengthen the term of your bond portfolio and may put your principal value of risk. As an investor, you need to understand the fine print and the term of your bond portfolio absent prepayments and calls. Your Private Investment Counselor can help you explore the real term of your bond portfolio.
- Quality Is An Important Driver
In the 1980s, investors and bond managers used to talk about "junk bonds." Today, this term has been replaced by "high yield bonds" and "the credit portion of your portfolio." Whatever the euphemism, we are talking about junk bonds. They aren’t illegal or immoral, but understand that they embody more risk than super-high quality bonds. Risk is okay, but you need to understand what risks you are adopting. How much of your bond portfolio is in "high yield" (a.k.a., junk bonds)? What is the quality of these bonds? Be sure that the quality of your bond portfolio is consistent with your particular needs.
- Currency May Be a Factor
Non-home-country bonds may, or may not, be a wonderful thing to have in your portfolio. Just be certain that you are willing to embrace the currency risk associated with these bonds. Some non-home-country bonds may be denominated in your home-currency and some may not. Are you comfortable with both the credit risk of the bond issuer and the currency risk associated with the bonds? The credit quality of issuers is dynamic and in recent years, the credit quality of some sovereigns has declined while the credit quality of others has risen. Further, some of the so-called emerging markets (e.g., Chile) are better credit risks than some of the old-line European bond issuers.
By way of summary, no risk no return. If you want to earn an investment return on your bond portfolio then you need to accept some risk. Otherwise, you should hold cash, which offers virtually no investment return. The key is to identify and understand the risks that are present in your bond portfolio and to evaluate whether those are the appropriate risks for your situation.
As always, if you would like to discuss transparency and risk management, please drop me an email at Jack@RGPIC.com or give me a ring at 617.945.5157. Meanwhile, please leave a comment in the Comment section just below this article, allowing us to have a lively interchange amongst my readers. Thank you.