Market Beat: Evaluating risk in fixed income portfolios
Investors face many different types of risk. Risk cannot be eliminated from investments but can be managed in various ways.
Bond portfolios are subject to a few different types of risk. One is default risk. That means that the issuer of your bond will not be able to pay your funds back and will default.
Some investors tend to “chase yield” when interest rates are low to increase income. What they do is purchase low-credit quality bonds, known as junk bonds to increase yield. Junk bonds can have a high default rate in times of recession.
The default rate has gotten as high as 40 percent in past recessions. Default risk can be managed by using investment grade bonds. The yield will be lower, but the default rate will also be much lower.
The safest bonds are U.S. Treasury bonds which are backed by the full faith and credit of the U.S. government. Corporate and municipal bonds are rated by independent credit rating agencies. By sticking with investment grade bonds with high-credit ratings, default risk can be lowered considerably. If you wish to have some high yield or junk bonds as a part of your investment allocation, that risk can be diversified by using mutual funds instead of individual issues.
Interest rate risk is another form of risk that fixed income investors face. Bonds will rise in price as interest rates fall and lower in price if interest rates rise. The amount that a bond will fall, or rise can be measured by using a complex mathematical formula known as the duration. The duration tells you how much your bond will drop in price with a 1 percent rise in interest rates. The duration can be calculated for individual issues and for your entire portfolio. If you have bond mutual funds, you’ll be able to find the duration for the fund.
If you’re concerned about the effect of rising interest rates on your portfolio, you can calculate the duration and take steps to lower the duration to a level that you’re personally comfortable with. Shorter term bonds will have a lower duration than longer term bonds. With the flat yield curve that we have today, the yield on short and intermediate term bonds is pretty good relative to longer term bonds.
There are several different strategies that can be used to help manage different types of risk.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.