The concept of bond risk is more complex than bond return. In Chapter 8, we presented a description of various fixed-income securities. We will now learn that bonds are more than mere legal documents. Investing in bonds means making decisions about risk and return, or more appropriately, about the income and capital appreciation an investor expects. It is true that many inves- tors do not like to assume risks. But they also realize that all investments have some degree of risk. Consequently, every investor should understand the risks of fixed-income securities.
Any discussion of bond risk begins with the realization that even bonds with identical maturities and YTM can have varying degrees of risk associated with them. Equally important, several types of risk have a major impact on bond prices, as will be discussed.
Key Fixed-income Risks
Interest Rate Risk. Interest rate risk refers to the variations in bond prices as a result of fluctuations in market interest rates. When market interest rates rise, bond prices decline, and the opposite is true when market rates drop. The reason is that when the interest rate rises, bonds with lower coupon rates fall out of favor, and their prices decline. Figure 9.1 demonstrates this relationship.
This figure also shows that the longer the maturity of a bond, the higher the impact of a change in interest rates on bond prices.
The interest rate–bond price relationship conceals an important fact. Even in the case of a safe, non callable Treasury bond, the impact of the rise in interest rates can be significant. For instance, Figure 9.2 reveals that a mere 2 percent increase in the interest rate would slash the price of a 30-year, 7.5 percent Treasury bond by 18 percent. Of course, the reverse is also true. In 2014, for instance, because of steadily declining interest rates, long-term Treasury bonds racked up total returns of close to 25 percent.
Bond Prices
Number of Years to Maturity
Interest Rates
$
%
30 20 10 5 1
Figure 9.1 Relationship of Interest Rates to Bonds Source: Author’s own work.
With 2% rise in rates With 2% fall in rates
–4% +6%
+13%
+24%
–11%
–18%
2.5 years
8 years
20 years
Figure 9.2 Bond Price Volatility (based on 7.5% coupon) Source: Author’s own work.
Inflation Risk. Inflation risk is the impact of inflation on coupon payments and return of the principal. If an investor holding a 10 percent bond receives an interest payment of 10 percent or $100 at the end of one year, and during the year the price level rises by, say, 6 percent, then the real interest rate (the nominal interest rate adjusted for inflation) would be 3.77 percent. So, assuming that the principal is received after one year, the buying power of $1,000 would drop to
$940 in real dollars, a loss of 6 percent.
Maturity Risk. Because the future is assumed to be uncertain, investing in a bond with a longer maturity always includes more risk than with a short- er-maturity bond. Because bondholders generally prefer shorter-term investments with lower risk, they require a higher risk premium for invest- ing in long-term securities. Borrowers are willing to pay the premium
Table 9.1 Investors’ Services Rating Classification
Moody’s General Description Standard & Poor’s
Aaa Highest Quality AAA
Aa High Quality AA
A Upper Medium Grade A
Baa Medium Grade BBB
Ba Lower Medium Grade BB
B Speculative B
Caa Poor Standing (Perhaps in Default) CCC–CC
Ca (Generally) in Default C for Income Bonds
C Lowest Grade (in Default) DDD-D
Source: Author’s own work.
because they want to be compensated for the impact of future increases in interest rates.
Default Risk. A bond yield reflects the borrower’s credit quality. Lower quality, or noninvestment grade bonds—those rated BB or below—generally offer higher yields than better quality issues, but they have more potential for price volatil- ity. The higher yield compensates the investor for lending money to a company that is considered more likely to default on interest and principal payments.
Thus, a rising yield (or falling price) on a bond may reflect a company’s deterio- rating financial situation rather than any overall rise in market interest rates.
Similarly, when a company’s financial situation improves, generally, yields on its obligations decline.
Callability Risk. Callability risk refers to the possibility that the bond is called before maturity due to falling interest rates. Then the bondholder would be compelled to invest the proceeds at a lower interest rate. Typically, if a bond is called, a premium over the maturity price is paid by the issuer to the bond- holder. This premium often varies directly with the remaining years to maturity.
A common premium for a corporate bond called at the end of the call protec- tion period would be one year’s interest.
Liquidity Risk. A bond may also be subject to liquidity risk. This risk refers to the price concession one must grant in order to quickly convert the bond into cash and receive the original investment. Generally the less liquid a security, the higher its liquidity risk. Table 9.1 presents a list of categories used by Moody’s and S&P to
rate corporate bonds. Typically, bonds carry these six types of risk that can be broadly measured in terms of the risk premiums associated with each type of risk.
Risk Reduction Strategies
Several risk reduction strategies applicable to bonds are available that have been effective. These are discussed below.
Laddering Bond Investments. Laddering bond investments is a commonly recommended strategy for bond investors, whether they wish to hold individual bonds or shares in funds. Laddering refers to the technique of buying bonds maturing at different times. This technique works best if investors buy bonds with maturities of 10 years or less. That way, every other year or so, as bonds representing 20 percent of their portfolio comes due, new bonds are purchased at the prevailing rates. With this approach, investors can systematically purchase bonds at prevailing market rates, which over time can help smooth out the overall volatility of their bond portfolio.
Diversifying with International Bonds. When foreign countries are still in a reces- sion, or are beginning to recover from a recession, higher interest rates are gen- erally offered by international bonds. However, investors going overseas for bonds should not let the relatively high returns tempt them into committing a disproportionate portion of the bond portfolio to these potentially volatile for- eign bonds. As a general rule, 10 to 15 percent of the total funds invested in fixed-income securities should be sufficient to increase the foreign exposure and achieve the diversification needed to help mitigate price and interest rate risks on domestic holdings. Investors in international bonds should always con- sider currency risk.
Investing in Tax-Exempt Bonds. Yields on tax-exempt bonds could provide an attractive investment vehicle, especially for investors who pay top tax rates. And in a high tax environment, increased demand for tax-exempt funds can help provide some support for municipal bond prices.
Adopting Dollar Cost Averaging Strategy. DCA—regularly investing a fixed amount in bonds—can be an attractive strategy for long term investment. This strategy can be effective when reinvesting bonds that came due, or when investments need to be shifted to reflect changing goals and needs. With DCA, investors may
buy more bonds or shares when prices are lower, and fewer when they are higher.
Of course, DCA does not protect against a loss in declining markets or ensure a profit in rising markets, and when selling their bonds investors could end up with a gain or loss.
Buying a Bond
As a general rule (with the exception of government bonds which are always presumed to be appropriately priced) it is advisable to purchase an underval- ued bond. However, since bonds are long-term obligations to pay a fixed number of dollars at maturity, several special factors should be taken into account when purchasing a bond.
Bond Yield. The critical variable in bond investment is its yield: given a fixed coupon rate, the lower the price of a bond, the higher its yield. Although there are many exceptions, when the stock market is up, at least in theory, the bond market weakens and vice versa. Consequently, the stock market bears careful watching when selecting a bond.
Two important caveats of bond yields deserve special mention. First, during periods of restrictive monetary policy, interest rates generally rise, thereby depressing bond prices and pushing up bond yields. Second, when short-term interest rates decline, investors start investing in long-term securities, which ultimately leads to a decline in the long-term rates as well. These factors should help a financial planner determine the appropriate time for investing in bonds.
Bond Ratings. Bond ratings regularly published by S&P’s and Moody’s facilitate the task of selecting attractive bonds. The ratings range from AAA for the safest bonds to D for highly speculative bonds which may even be in default. The rat- ings of A or better are given to investment grade bonds, while speculative bonds are rated lower than BB.
Current Yield and Yield to Maturity. The current yield on a bond is the ratio of the current coupon payments to the current market price of that bond. The YTM is the interest rate at which the present value (PV) of all future coupon payments and the face value (the principal amount paid at maturity) of the bond equals its current market price. The YTM is the true interest rate underlying any bond. The current yield provides a good approximation for the YTM for longer maturity bonds.
Assume, for example, that a 10-year maturity $1,000 face value bond which carried an 8 percent coupon ($80 in interest payment each year) was issued one year ago. Naturally, at the time of issue, the bond price was $1,000 (equal to the value of ten $80 coupon payments and the principal payment of $1000 in the 10th year discounted at 8 percent interest rate), and both the YTM and current yield ([$80/$1000]x100) are equal to 8 percent. Now assume that because of an increase in the market interest rate the bond price has fallen to
$884.82. The current yield on the bond ($80/$884.82) is 9.04 percent and the YTM is 10 percent (which is also the market interest rate). That is, $884.82 is the PV of nine $80 coupon payments (since one year has elapsed since the bond issue), $1,000 face value to be paid in the ninth year (now the maturity date) discounted at 10 percent interest rate. In technical jargon, this bond with 8 percent coupon is priced to yield 10 percent at $884.82. The PV concept that underlies the determination of bond price was presented in detail in Chapter 3.
Selling a Bond
Selling a bond is a complex process that requires a different discipline than that required for buying a bond. This can become a challenging task, and it is best to check the following points before making the final decision.
Underperformance. This is the most challenging task faced by an investor. First, what time period should be selected for checking the performance: six months, five years, or something in between? While there are no set rules to follow, pru- dence dictates that the shortest period to be selected is 12 months but the lon- gest period should be no more than three years.
Change in Company Position. If the financial condition of the bond issuer has changed significantly, resulting in the downgrading of the bond’s rating, then serious consideration should be given to liquidating the holding.
Extent of Loss. It is important to calculate the extent of the loss, since the real loss in the bond holding could very well be less than what appears on the surface.
Tax Consequences. Whether the sale of the bond would result in a gain or loss, one should assess every situation carefully, so the bondholder can fully utilize either the resultant gain or loss to minimize the overall tax burden.