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Be safe with your safe money

Fiscal Cliff MTNews

By Chris Evers

Investors should not be so focused on reducing interest rate risk that they turn a blind eye to all other risks in the bond market.

The impending rise in interest rates will hurt the value of bond portfolios. When rates rise, bonds lose value because, everything else equal, an old bond paying 3% is worth less than a new one paying 4%.

As investors attempt to remove fixed-income investments that are heavily exposed to the Federal Reserve Board’s inevitable raise in rates, many have turned to nontraditional bond funds to provide bond exposure with less interest rate risk.

Investors who are viewing nontraditional bond funds as safe money could unknowingly be exposing their portfolios to an inappropriate level of risk.

The nontraditional bond fund category tripled its asset base in the last three years while the total mutual fund universe barely doubled, according to data from Morningstar. Nontraditional bond funds use sophisticated fixed-income investment strategies such as investing heavily in high-yield corporate bonds, foreign or emerging-market debt, derivative products and bank loans.

They may have a place in a diversified portfolio, but they should not be mistaken as a core bond holding.

In all market cycles, investors need to hold safe money aside. Investors who are viewing nontraditional bond funds as safe money could unknowingly be exposing their portfolios to an inappropriate level of risk.

Duration matters

Interest rates and bond prices move in opposite directions. The longer the duration of the bondthe greater the impact the rate change has. Here’s the math:

Multiply the duration by the change in rate.

So if you have a bond fund of 30 years in average duration and interest rates go up half of a percentage point, the value of the fund drops by 15% (30 times 0.5). If the average duration is shorter – say five years, the value drops less – in this case, 2.5% (5 times 0.5).

The more traditional approach to bond management suggests that intermediate-term, high-quality bonds provide superior risk-adjusted prospects for periods of rising rates. As rates slowly rise, interest payments offset the decrease in the face value of the bonds while maturing bonds can be reinvested to take advantage of the higher rates.

The speed and size of the change in rates is important. If rates rise aggressively, even intermediate high-quality bonds could struggle to make it in the black. Gradual rate increases, on the other hand, allow short- to intermediate bonds to better capture the higher reinvestment rates.

Most experts expect the slow-rise scenario due to the fact that the Fed plans on raising rates simply to normalize them or return them to neutral after having been historically low for over seven years.

That is far different from the Fed raising rates aggressively to beat down inflation, which has yet to appear on the horizon. Commodity prices have fallen, and wage increases have been nothing to write home about.

Nontraditional bond funds use many approaches that try to reduce a portfolio’s sensitivity to interest rates. For example, foreign bonds may be able to withstand Fed tightening because they are more correlated to their respective country’s monetary policy. High-yield corporate bonds, as indicated in the name, pay out a higher interest rate, which can effectively lower their duration. This is due to the larger interest payments, which return the bond’s face value quicker to creditors, therefore allowing them to reinvest at higher rates.

Investors trying to reduce interest rate sensitivity must understand that these strategies can expose their portfolios to other forms of risk, namely:

  • Credit risk – the likelihood of a bond issuer being unable to honor its obligations. Investors are rewarded with a higher interest rate on their bonds but can be less secure that their principal will be repaid.
  • Liquidity risk – the chance that the investor trying to sell a security cannot find a buyer. Some areas of the market, such as high-yield corporate debt, tend to have higher liquidity risk because there are fewer investors in the market for their securities. For example, many pension funds have requirements on the credit rating of their investments, which prohibits them from investing in high-yield debt, therefore removing possible buyers of that debt.
  • Currency risk – the possible fluctuations of value based on foreign exchange rates. Movement in currency valuations can cause an investment to lose value once it is converted back to the investor’s local currency. The rising value of the U.S. dollar in the last 12 months has resulted in a strong headwind for foreign investments because foreign currencies buy fewer dollars. Currency risk cuts both ways. When the dollar declines in value, it can provide a tailwind for foreign investment returns.

Many nontraditional bond funds will lower their sensitivity to rates by replacing interest rate risk with one or a combination of these other forms of risk. Unfortunately, the characteristics of these investments tend to cause them to be more volatile and behave more similar to stocks.

During the 2008 financial crisis, the high-yield debt market lost about 40% because investors began to question the solvency of lower-credit borrowers. Liquidity risk also played a role. As investors fled the high-yield market, many struggled to find buyers, thus forcing sellers to accept lower and lower prices.

Learn more

Understanding Bond Risk, from the Financial Industry Regulatory Authority
Bond investors look at credit quality, a Money Talk Video

Bonds are a bastion of safety. They provide investors the confidence to take on the risks of stock ownership. But nontraditional bond funds at times act more like stocks.

The purpose of fixed income in a portfolio is to protect investors on the downside and to provide some non-correlated returns from stocks. Investors should examine why they hold a nontraditional bond fund in their portfolio. While a small allocation can help provide further diversification, using such investments as safe money is a mistake.

Chris Evers is a registered representative and associate at Landaas & Company.

(initially posted June 3, 2015)

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