Tahoe-Truckee Market Beat: Fixed income risks and strategies
Investors face many different types of risk. Most people tend to think of risk as the possibility of losing capital and that is certainly a risk especially with individual stocks or low rated bonds.
Default risk is high with junk or high yield bonds and can be especially high during times of recession. That risk can be lowered through diversification.
Inflation risk is the risk of your capital not keeping pace with inflation. If you’re too conservative and the return on your portfolio is lower than the rate of inflation, you will lose purchasing power.
Interest rate risk is similar because we usually see rising interest rates during times of inflation. The market value of bonds will drop as interest rates rise.
The amount a bond will move down with an increase in interest rates can be measured by a formula known as the duration. The duration of an entire bond portfolio can be measured, to let you know how volatile your portfolio is.
The most recent CPI, consumer price index, report showed inflation was up +0.6%, last month, the largest increase in four years. So, we are starting to see some lift in inflation, even interest rates haven’t been rising much.
There are a variety of strategies that can be used to manage interest rate risk. One is known as a ladder, where the investor ladders the maturities out over several years, that way you can reinvest at the higher rates as issues mature.
The barbell is another common strategy; with a barbell you’ll have both short and long term maturities and not much in the middle. A bullet is a strategy where all the maturities are focused on the intermediate term, nothing very short or long.
Today there are stated maturity mutual funds, so investors no longer have to use individual issues for the strategies discussed above. Now, you can have some diversification and still have control of your maturity dates.
Step up bonds can also be useful during rising rate environments. Step ups will increase their coupon rate at regular intervals. It’s very important to understand the call provisions of step up bonds, if they are callable, they could get called right before a payment increase.
TIPs or Treasury Inflation protected bonds can also help in inflationary periods. They pay a set coupon rate, plus an inflation adjuster based on the CPI.
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.
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