Tahoe-Truckee Market Beat: Managing both interest rate risk and default risk
June 29, 2015
Many investors today are concerned about the effect of rising interest rates on their portfolios. Income investors have been struggling with record low interest rates in recent years, and many people have been "reaching for yield" by moving funds from investment grade bonds into high yield bonds and dividend paying stocks to maintain their income levels.
Investors face different types of risk. Fixed income investors need to be concerned about interest rate risk and default risk. Interest rate risk means that the market value of your bonds will decline in a rising interest rate environment. However, if they don't default, you'll get your investment back at maturity.
Default risk is the risk of a bond issuer defaulting on the payment, and if that happens you may not get your money back at all.
High yield bonds can have fairly high default rates. Default rates for high yield bonds are typically higher in times of recession than when the economy is strong.
One way to lower your default risk in high yield bonds is to diversify. This may be an area where a mutual fund makes more sense because you can diversify a relatively small amount of money and have a professional manager.
The problem with using bond funds compared to individual bonds is that with individual bond holdings, you control the maturity dates you select and with a mutual fund that is out of your control.
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One way to invest in a bond mutual fund and manage your interest rate risk is to use a fund with a stated maturity.
There are high yield bond funds available that pay monthly income, have a respectable rate of return and have the maturities limited to five years.
So, you can purchase a diversified fund today that pays reasonable income and know that if we enter a rising rate environment, the fund will mature in five years and your initial investment will be returned.
Stated maturity funds are one way to manage both interest rate risk and default risk with one investment.
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.