A Lesson You’ll Bond With—Part 3Monday, November 8th, 2010 by Charles Mayfield, CFP®
Welcome or our final chapter of Bond Basics! As investors, we tend to assign less risk and more safety to these types of investments. While this is a true generalization, NO investment is without its risks. To wrap up this three part series, I’d like to discuss some of the risks that are associated with bonds and some ways to mitigate them. There are two fundamental risks to bonds that I’d like you to be familiar with: Market Risk & Interest Rate Risk.
Market Risk: Bonds are an investment, just like equities. They have a price at which they can be bought and sold on any given day. We have already discussed the price at which most bonds come to market, the “issue price.” Once any bond has been purchased, the price at which you can turn around and sell it will fluctuate based on several factors.
- Interest Rates: if interest rates rise, prices for existing bonds tend to fall.
- Up/Down Grading a Bond’s quality: A bond is rated based on the likelihood that the issuing agency or company will be able to pay back the debt in a timely manner. If the rating of your bond goes down, the price will likely follow. This is sometimes referred to as “credit risk”.
People tend to purchase bonds with the assumption that they will hold them to maturity. In this case, market risk is less of a concern. Market risk becomes relevant if and when the bond holder decides to sell the debt and finds that its current value is less than original issue price.
Interest Rate Risk: “I thought the interest was fixed on a bond?” Yes, you are correct. Most bonds have a fixed interest rate, the coupon. When a bond matures the holder is paid back their initial investment. Interest rate risk comes into play when the investor goes looking to replace the bond that has just matured. If prevailing interest rates have dropped, the investor will be forced to invest more money to receive the same income.
Example: John’s ABC Bond matures and he is paid $1,000. It was a 10-year note paying 8% semi-annually ($80/year in interest). If prevailing interest rates for a brand new 10-year note are 6%, the investor would have to invest over $1,300 to get the same $80 payment.
Now that we have talked about several of the predominant risks associated with bond, let’s discuss a few ways to guard against them.
Proper Allocation: If you have been following our blog for a while, you know that we typically recommend a client allocate between 25-40% toward Fixed Income. Investors tend to overweight their allocation to bonds as they age and this can further exacerbate these common risks. We typically recommend further diversification among different types of fixed income investments—Corporate, High Yield, Treasury and Municipal bonds).
Bond Laddering: This technique involves buying bonds with varying maturities. We already know that longer maturities tend to have higher coupons. Focus on spreading your investments out across a broad spectrum of maturities. This can alleviate the ugly side of interest rate risk when rates fluctuate.
In summary, having a basic understanding of how bonds work, on their own and as part of an overall investment plan, can go a long way to helping investors mitigate risk and maximize returns. While CERTIFIED FINANCIAL PLANNER™ practitioners exist to help set investors up for financial independence, we truly believe that knowledge is power. Invest wisely.
Bottom line, talk to your investment advisor. Bonds are a critical component to long term performance. Be sure you have all the facts before you invest.