October 26th, 2011
Stanley from Sturgis, SD:
What are the risks in owning a fixed income portfolio?
Friedenthal Financial:
Great question! At a high level, there are 4 major categories of risks in fixed income. Many fixed income instruments (aka “bonds”) bear more than one of these risks, and of varying magnitude. It’s very important to understand any instrument you own, including how these risks interact with each other. Having said that, the 4 major risks are as follows.
Interest Rate Risk – This is the risk that the coupon/rate you are receiving becomes below market in the future. All else equal, a longer maturity bond (or fund) has more interest rate risk because you could be “stuck” with a below market rate for a longer period of time. The greater the interest rate sensitivity, the more the current value/price of the bond will decline for a given increase in market rates for like securities.
Credit Risk – The risk that an issuer of a bond will default, causing a reduction in interest and principal received by the investor. This is germane in examining Corporate Bonds, Municipal Bonds, and many foreign Sovereign Bonds. We typically describe US Treasuries as “risk free”. Even with this year’s unprecedented rating downgrade by Standard & Poors to AA+, US bonds still behave like they are the global risk free instrument. Keep in mind that this ONLY refers to credit risk. Clearly US Treasuries have interest rate risk (see above).
Liquidity Risk – This is the cost differential between what you pay to buy a bond and what you receive when you sell it. Sometimes we think of this risk as probability you won’t receive what’s marked in your brokerage statement when you go to sell your bond. Individual corporate and municipal bonds can bear a great deal of liquidity risk. Mutual Funds and Exchange Traded Funds often provide much better liquidity than the bonds inside the funds.
Prepayment Risk – This is the risk of “timing” of cash-flows expected. It is specific to Mortgage Backed Securities and Callable Bonds. Since the investor doesn’t have control over when the borrower (mortgages) pays off the loan inside the bond, or when the issuer calls (forces redemption) their bond, cash-flow timing can be uncertain.
Keep in mind that all of the above risks are for individual securities. Diversification is very important in a fixed income portfolio, ESPECIALLY one with sensitivity to Credit Risk. For this reason, we generally recommend that investors use bond funds (mutual funds or ETFs) to own their fixed income exposure.
Please also note that bonds with material credit risk tend to be more highly correlated to stocks than to treasuries. As poor economic indicators frequently cause stocks to decline, they also suggest that corporations may have higher default rates, causing credit sensitive bonds to decline in value. These scenarios are often accompanied by increasing long term treasury prices (lower rates).
The charts below show scatter plots of the % changes in High Yield Bonds (JNK) vs Stocks(SPY) and the same chart against Long Term US Treasuries (TLT). If you look at the statistics on the right hand side, you will see that JNK has a 49% Correlation (R-Squared) to stocks compared to 6% to TLT.
JNK vs SPY
Source: Bloomberg
JNK vs TLT
Source: Bloomberg
The last chart represents the price changes in three different treasury funds of varying maturies over the last 4 years. As discussed above, TLT(white line) has muct more volitility due to interest rate risk. IEI (Orange line) is a intermediate term treasury fund and exhibits less volitility than TLT, but more than SHV(Yellow Line) which is a short term treasury fund. To see this chart in more detail, click on the chart.
Source: Bloomberg
We hope that helps and provides fodder for discussion. Please let us know if we can be of further service!
The Friedenthal Financial Team
856-210-6494 (Office)
856-210-1565 (Facsimile)
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