Bonds are on people’s minds now—and for good reason. You may have seen Bedel Financial Consulting’s recent article about negative interest rates or you may have read about the inverted yield curve. Review the bonds in your portfolio to determine the risk associated with each. Not sure what to look for? In this article we’ll highlight the more common risks with bonds and how they can impact your portfolio.
Duration measures a bond’s sensitivity to interest rate changes. The higher the duration the more the value of the bond will change when interest rates move. A decrease in interest rates will increase the value of the bond. For example, if you bought a bond two months ago that yielded 3 percent and today similar bonds have a yield of 2 percent, your 3 percent bond is worth more.
A less obvious component of duration is reinvestment risk—how the cash flows of a bond can be reinvested. If you own a bond that provides you with high, regular interest payments, you can reinvest those payments throughout the life of the bond at the going rate. However, a bond that pays all of its return upon maturity has a greater reinvestment risk since you have to wait until it reaches maturity to lock in a new interest rate.
To limit the duration risk of your portfolio, purchase shorter-term bonds instead of longer-term bonds and, possibly, higher yielding bonds in lieu of lower yielding bonds. I say “possibly” because higher yielding bonds have their own risks, particularly credit risk.
Credit risk refers to whether the borrower is likely to repay its debts. Higher credit risk suggests a greater possibility of default—in other words, the borrower is more likely to fail to make good on its promises. Credit risk is mostly associated with corporate bonds. Events such as recessions can have significant impacts on credit risk. Lower sales, lower profits or greater losses can make it more difficult for a company to make good on an interest payment or a payment upon maturity. They can also make it more difficult for companies to move new debt in order to pay off the old, which leads to liquidity risk.
Liquidity Risk - Issuers and Investors
The most underappreciated risk for bonds just may be liquidity risk. Issuers assume most debt will be refinanced at a later time. But here’s the risk. When those bonds mature, can the issuer (company) successfully refinance the debt? If not, then the company will have trouble paying off the maturing bonds.
Refinancing became a big concern during the 2008-09 financial crisis. At that time, there was little appetite for purchasing corporate debt. Companies which needed to refinance struggled to do so. Furthermore, when they were able to refinance, their new debt was often at a significantly higher cost than their maturing debt. Given the historically high levels of corporate debt today, refinance risk could play a big role in bond portfolios over the next several years, especially if the demand for corporate debt falls.
As an investor, you need to understand the liquidity risk of your holdings. Ask yourself these questions: If you need to sell from your bond portfolio, can the holdings be sold? More importantly, can they be sold with minimal cost? Owning individual bonds can be cost-effective, but if you have to sell a $10,000 municipal bond before maturity, you might lose 5 percent in the transaction. On the other hand, you can often sell a bond mutual fund at the net asset value without a discount.
Foreign Exchange (FX)
If you hold foreign debt denominated in local currencies the value of your interest payments and maturity payments will be affected by the value of that country’s currency. If you want to lessen the FX risk of your foreign bond portfolio, look for U.S. dollar-denominated debt.
Now that you’re familiar with some of the biggest risks to your bond portfolio, don’t forget about other risks such as the political environment, catastrophic risks and changes to tax laws. Despite these risks, bonds can still be a relatively safe financial vehicle and an effective anchor for a diversified portfolio. Become an informed investor and make sure you are comfortable with the risks that you are taking.
Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.