Bonds also face investment risks
Joel Dresang: Tom, let’s talk about the fixed income or bond side of investors’ portfolios. A lot of people don’t realize that they face some risks in that side, even though that’s considered the safe place for their money.
Tom Pappenfus: Absolutely. Even though it is considered the safe side of your portfolio, meant for preservation of principal, it is important to understand that there is some volatility that can take place there as well – especially now that we have entered into a rising interest rate environment.
Joel: Explain that.
Tom: Well, this past December, the Federal Reserve decided to hike our interest rates by a quarter point. Now, this is the first time it’s happened in several years, but more importantly it signals a transition from a generally declining interest rate environment to now a rising interest rate environment.
There’s an inverse relationship between interest rates and bond prices so that as interest rates may be going down, which has happened in the past, bond prices have gone up. Now that we’ve entered into a rising interest rate environment, that will supply some downward pressure to your bonds.
Joel: What sorts of risks should investors be concerned about?
Tom: So, the main risks that we’re looking for and that they should be aware of would be the interest rate sensitivity, measured by duration. You want to understand how much your portfolio may move with any interest rate change, which is largely impacted by the maturities of your bonds.
You also want to understand the credit quality, whether or not you have higher credit quality, safer types of corporate bonds, or you might have lower credit quality, junk, high yield type of debt, which is more subject to defaults.
On a more bond specific basis, you’ll want to have an understanding of the liquidity of that bond market. It’s important to know that as your fund manager may need to sell a bond, there needs to be someone on the other end of that transaction to purchase that. If not, you may be selling that bond at a discount.
Joel: How can investors assess the risks in their bond portfolio?
Tom: The way investors can assess and the way we like to assess the risks in your bond portfolio is through the Morningstar Snapshot, which provides that overview, aggregate look at your portfolio and its holdings.
You want to look and identify where that duration statistic is, to measure that sensitivity to interest rate movements, and also it provides a nice breakdown of the different types of credit quality, broken by different tiers from higher credit quality down to lower credit quality.
Joel: So that’s the aggregate level. What about the individual bond funds? How important are those?
Tom: It’s important to understand the funds that you hold and what their investment philosophy may be. You want to understand what the individual holdings are, understand what types of bonds they can hold per their investment charter, and also have an understanding of what that bond fund has done in the past. That might provide some indication of how it may react in the future.
So, it’s important to understand how your fund may change or evolve over time. You may think you have little to no exposure to lower credit quality, riskier types of bonds. But over time, you may see that fund managers – or we have experienced fund managers – that may start to reach for yield, to bolster returns. And you may have exposure to risks you weren’t aware of in the first place.
Joel: So, the Financial Industry Regulatory Authority has done some research showing that fixed income investors don’t often know that they do face some risks in that part of their portfolio so it seems like this is a good reminder.
Tom: Absolutely. You should always be prepared and understand that even the safe side of your portfolio does have its risks and can have volatility. This becomes especially important as investors near retirement or are already in retirement, as you depend on a more stabilized portfolio and may depend on that for income as well.
Tom Pappenfus is an investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
(initially posted April 8, 2016)