From the Frying Pan into the Fire?
Risk in the Safety of Bonds
To paraphrase Yogi Berra, it seems like déjà vu all over again. At times in the past, interest rates were relatively low and rising. Today, I see people making the same mistakes they did then. They are buying the wrong kinds of bonds and bond funds. In an effort to solve one problem, they create others.
Whenever rates are low people seem to recognize some of the risks they are exposed to with fixed income investments. The primary risks income investors face are:
- Reinvestment Risk – the risk that when a security matures an investor will not be able to get as high a rate of interest as the maturing security;
- Credit Risk – the risk that interest and/or principal payments will not be made;
- Market Price Risk – the risk that interest rates in general will rise causing the market value of a security to drop;
- Tax/Inflation Risk – the risk that after taxes the income from a security will fail to keep up with inflation.
For an example of reinvestment risk, $100,000 in the average money market fund in 1990 would have yielded $7,700 in income. By 1993, the same investment would have only generated $2,699. From 2000-2003, the average money fund yield went from 6% to 0.6%. Today we are getting less than that. So much for the “safety” of money markets.
Measure Risk & Return
In an effort to get higher yields, many assumed more credit risk or market price risk. Much of the time they didn’t even realize they were doing this. They would fixate on the current yield of a bond and ignore a simple fact: the yield was higher for a reason – there was more risk. This led them into corporate bonds and preferred stock offerings. Those things pay higher current rates precisely because there are doubts as to the issuer’s ability to make the payments. Remember this tip: If the seller could pay less interest to someone else, they would not offer the high rate to you.
The other way to get a higher yield was by extending the maturity of the securities. Typically, the longer the period until maturity then the higher the yield. One problem with extending the maturities is that the market price becomes much more volatile. Consider what happened to purchasers of a 30-year government bond in 1993. Government bonds are considered to be free of credit risk. On 8/15/1993, a 30-year bond was issued paying at a rate of 6.25%. During 1994, as interest rates increased, the market price of the bond went from 100.97 down to 78.27. The “safe” government bond dropped over 22%. Ouch!
Nothing is Perfect
Interest rates are just as unpredictable as the stock market. Sure we may be able to predict what the Fed will do at its next meeting to ultra short-term rates (the only rates it actually controls), but the financial markets are open everyday and rates bounce around in anticipation of what may come next.
Historically, fixed-income investments have been horrible choices to combat long-term after-tax inflation risk. Fact is there is no perfect fixed-income investment that will combat all the risks I listed earlier. We can’t avoid risk. All we can do is manage the risks and focus on what we can control.
Safety in Diversity
Most people should own bonds as part of their holdings. Keep bond holdings broadly diversified. Keep portfolio taxation to a minimum. Keep credit quality high, stagger maturities and keep to the short to intermediate term issues. Yes, when interest rates rise, the market price of bond holdings will decrease but, you will be reinvesting the interest and maturing securities at the higher rates. Managed well, the decline in value is only temporary. Finally, while others are out chasing the returns of what has been hot lately (and chasing their tails a bit), I would focus on managing your risks and watching your step.
Dan Moisand, CFP has been featured as one of the America’s top independent financial advisors by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines. He practices in Melbourne. You can reach him at (321) 253-5400 or email@example.com
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