Tahoe-Truckee Market Beat: Risks in the bond market
Special to the Sun
Investors buy bonds for multiple reasons including both income and the safety of their principal. Many investors have portfolios that contain both stocks and bonds and change their allocation over time to become more conservative as they age.
It’s important to know that bonds are not riskless and are subject to different types of risk.
One type of risk is interest rate risk. Bonds go down in value as interest rates rise. The amount a bond will fluctuate with interest rates can be determined by a complex mathematical formula known as “duration.”
The duration formula includes factors like the coupon rate, yield to maturity and call provisions of the bond. If you bond doesn’t default, you’ll get your principal back at maturity, but the price of the bond can fluctuate considerably prior to the maturity date.
Inflation risk can occur if you own a long-term bond and the rate of inflation exceeds your yield to maturity. You won’t lose dollars at maturity, you’ll lose purchasing power. In other words, your real rate of return that is adjusted for inflation could be negative.
Default risk is one of the risks that really worries investors, as it is the risk of the bond issuer defaulting and not paying your principal back to you at maturity.
Default risk can be substantial with high yield or junk bonds, especially in times of recession. Default risk can be managed by diversification if you want exposure to junk bonds in your portfolio.
Another way to minimize default risk is to stick to investment grade bonds that have a very low default rate. US Treasury bonds are backed by the full faith and credit of the United States government.
Certificates of deposit are insured by the FDIC. Many municipal bonds are insured and are also backed by the state in which they are issued.
Foreign bonds can be attractive and will provide additional diversification to a bond portfolio, but can also subject investors to one more type of risk, which is known as “currency risk.”
Currency risk is the risk of the currency that your foreign bond is denominated in weakening in terms of the US dollar. So, even if interest rates cooperate and the issuer doesn’t default, you could still take a loss if the foreign currency is substantially lower when the issue matures.
When evaluating fixed income for your portfolio, it’s important to understand the types of risk to which you may be exposed.
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.