Risk Management 2 - A Risk Drill for Your Bond Holdings

Investors venturing into lower-quality bonds can suffer punishing losses during economic shocks, when such credits often tumble due to worries about whether issuers will be able to make good on their obligations.

Christine Benz 26 May, 2016 | 14:26
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Over the past decade and a half, the Barclays Aggregate Bond Index has been just one fourth as volatile as the U.S. equity market, as measured by standard deviation. That's not to say that bonds don't court some risks, however. Investors venturing into lower-quality bonds can suffer punishing losses during economic shocks, when such credits often tumble due to worries about whether issuers will be able to make good on their obligations. And in recent years, the main preoccupation for many bond investors has been the possibility of higher interest rates, which spell trouble for bond prices. As you survey your bond holdings today, here are some of the key questions to focus on, as well as details on how to find the answers.

Question 1: How interest-rate sensitive is the portfolio?

Rising interest rates can be welcome, particularly for today's yield-starved retirees. But when new, higher-yielding bonds hit the market, that hurts the prices of already existing bonds with lower yields attached to them. The longer the duration of a bond portfolio, the more vulnerable it will tend to be to interest rate increases. That's because not only will investors in the long-duration bond be stuck holding a lower-yielding asset when rates increase, but they will be forced to hold on to it for a longer period of time, increasing their opportunity cost. Investors can mitigate interest-rate risk somewhat by holding individual bonds until maturity, but it can be difficult for smaller investors to build well-diversified portfolios composed of individual bonds. Moreover, even if they buy and hold a bond, they'll still face opportunity cost if rates trend up. Investors can also reasonably match bonds' durations to their time horizons. Most intermediate-term bond funds, meanwhile, have durations in the neighborhood of 4.5 to 6 years.

Question 2: How vulnerable is the portfolio to an economic downturn and the stock market?

Another key risk factor for bonds is credit risk--the possibility that a bond issuer will be unable to pay its debts. To help make up for this risk, bond issuers with lower credit qualities typically must pay their bondholders higher yields than high-quality firms issuing bonds of the same duration. Default risk isn't the only reason that holders of lower-quality credits can run into trouble: In periods of economic hardship, such as the 2008 financial crisis, investors often sell out of low-quality bonds pre-emptively, thereby depressing their prices. That makes lower-quality bonds and bond funds less-than-ideal diversifiers for investors' equity holdings, in that their performance will often be directionally similar to stocks. Higher-quality bonds and bond funds are better diversifiers for stock-heavy portfolios.

Question 3: How big a risk is inflation?

Investors earning a fixed yield on their bond investments will see a decline in their real, take-home yields (that is, their purchasing power from that bond investment) as inflation increases. Because most bonds are vulnerable to inflation risk, investors drawing upon their bond portfolios for living expenses should take care to add inflation protection to their toolkits. Inflation protection is less important for investors who aren't in drawdown mode, as discussed here.

Question 4: Does the portfolio hold a lot of illiquid bonds that could be difficult to sell in a pinch?

The market for U.S. Treasury bonds is the most liquid in the world. The market for some other bonds? Not so much. Liquidity risk--the chance that an investor would want or need to sell a bond but find no ready buyers--came to the fore in late 2015. Third Avenue Focused Credit, facing shareholder departures and finding few buyers for its holdings except at punishingly low prices, took the unusual step of not allowing additional redemptions. Director of fixed income manager research Sarah Bush discussed liquidity risk. In general, it tends to be a bigger risk for categories like high-yield and less problematic for funds with the bulk of their assets in high-quality bonds.

Question 5: Is currency risk in the mix?

Holders of foreign bonds face all of the same risks outlined above, but they may also face a few additional risk factors. One of the most notable is currency risk--the chance that the currency in which the bond is denominated falls relative to the investor's home currency, thereby reducing or even wiping out any appreciation from the bond itself over the investor's holding period. Some foreign-bond funds hedge their currency exposures to effectively wipe out the effects of currency fluctuations on returns, thereby reducing volatility and making returns more bond like. Others explicitly focus on bonds denominated in foreign currencies. This is obviously a bigger risk factor for investors in world-bond and emerging-markets bond funds than domestically focused bond funds.

 

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About Author

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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