“Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.” – Howard Marks
The main risk most investors worry about in their portfolio comes from stock investments. Stocks can be volatile, especially in the short-term, and they run the risk of large losses.
Bonds are generally used for income and a reduction in volatility. Because of the steady stream of cash flow payouts, bonds have been more stable with both lower gains and smaller losses than stocks in the past.
Most investors assume that bonds don’t really carry much risk. The assumption is that since you receive interest payments on a periodic basis with bonds that they will consistently return the amount of your coupon or income payment and that’s all there is to it.
And if you look at the performance of bonds in the past 30+ years there is no reason to think that there are huge risks in the bond market. The Barclays Aggregate Bond Index, which is a broad gauge of the investment grade bond market in the U.S., has only had two down years since 1980.
And those annual losses were only -2.92% (1994) and -0.83% (1999). This is an incredible streak. In that time returns have been close to 8% a year, not much worse than stocks.
So does that means bonds carry little to no risk? Unfortunately most investors haven’t been around in an investment period when bonds have shown poor returns or consistent losses.
Assuming there are no risks when investing in bonds would be a mistake. This can be amplified by the recency bias that causes us to extrapolate our most recent experiences into the future.
Bonds have been in a bull market for a long time now and it’s hard to change your mind-set when something has been working for so long.
Unfortunately there are risks in the bond market. They are not the same risks that you see in the stock market (extreme volatility, large losses in a short amount of time, etc.). Bonds have their own unique risk characteristics. What follows is an outline of some of the most important risks to think about when investing in bonds.
Interest Rate Risk
Interest rate risk is the one that has most investors nervous at the moment. With rates at historic lows this has bond investors on edge. Bond prices and interest rates are inversely related so as one rises the other one falls and vice versa.
With falling interest rates the bonds you hold are more valuable because you earn more than the prevailing market rate. But as market interest rates rise your bond will be worth less because investors can get higher rates now than the bond you are holding.
Interest rate risk has actually increased in the last couple of months as rates have risen in a short period of time. In the month of May alone the 10 Year Treasury yield jumped from 1.64% at the beginning of the month all the way to 2.16% by month end.
Because of that increase in rates, the 7-10 Year Treasury ETF (ticker IEF) fell 3.4%. That’s a pretty decent one month decline for bonds and it shows you that bonds can lose money in certain investment environments.
Interest rate risk is one of the most heavily discussed topics in bonds today and there are a lot of points to make on this subject so I will devote an entire post in the future to this in my bond investing series.
Duration risk is an offshoot of interest rate risk. Duration simply measures the price sensitivity of bonds to a change in interest rates. There are many complex mathematical calculations involved with duration, but since I like to keep things simple I will skip all of the complexities and just go over what it actually tells you.
The ETF version of the BC Aggregate Index is ticker symbol AGG. Type AGG into Morningstar’s website and click in the portfolio tab and scroll down to the Bond Statistics. Here is what the duration statistic looks like on this page:
It’s not a perfect relationship but what duration generally tells you is how much to expect your bonds to change in price when interest rates change by 1%. So if rates were to go up 1%, you could be expected to lose a little less than 5% in the price this ETF (again, rates and bond prices have an inverse relationship).
You would still earn the interest rate on the fund, which is currently 2.4%, so you would have a total return of -2.5% or so over a year in this case. Actual performance could be slightly different depending on a number of factors, but you can use duration as a general rule of thumb to see how interest rates could affect your bond investments.
Let’s test out duration in a real world example with the IEF returns for May that I discussed above. The duration for IEF is currently around 7.5 years. So when rates rose 0.52% in May and IEF was down 3.4%, this was actually pretty close over a one month period (7.5/2 = 3.75 which is close enough).
All else being equal, the longer the maturity of your bond or bond fund, the higher the duration is. This makes sense since you would expect a 30 year bond to have a higher rate of interest than a 5 year bond since it would take you much longer to get your principal investment back. That means longer maturity bonds will be much more volatile than shorter maturity bonds.
It’s unclear whether or not inflation affects stocks in a positive or negative fashion. Some companies are able to pass on higher costs to customers while others are not. But it is clear that inflation is a negative for bond investments.
Inflation is a general rise in prices. That means that your money today will buy fewer goods and services in the future. Since bond interest payments are fixed, that means that they will get eaten up by inflation over your investment period. For this reason, bonds generally are a bad investment in periods of rising inflation.
This is the same reason that holding your investments in a savings account or cash over the long-term turns out to be a horrible investment.
There are bonds that you can buy that protect against inflation, called TIPS (Treasury Inflation Protected Securities). The interest rate of these bonds is fixed but the principal increases with the inflation rate.
This unique feature can be a great diversifier for the bond portion of your investment portfolio. Typical bonds perform well in periods of deflation of dis-inflation (falling inflation) while TIPS perform well in periods of rising inflation (or expected inflation).
Credit risk has to do with the credit quality of your bond or bond fund. This is simply a rating given to a bond that is similar to the FICO score you would receive on your individual credit report. AAA is the rating with the best credit quality and anything below BB is considered non-investment grade or junk bond status.
The lower you go on the ratings scale the higher the yield and the higher the risk of possible non-payment (or default). Think of non-investment grade as those borrowers who are riskier and will potentially have a tougher time paying off their debts.
Here is what the credit ratings scale for AGG looks like on Morningstar:
As you can see the AGG is made up almost entirely of investment grade bonds. That means it is higher on the quality spectrum and lower in the risk spectrum when compared to lower quality bond funds (all else equal).
Bonds also run the risk of having their credit rating downgraded which could affect the price the market is willing to pay for it so this could cause a loss of capital.
It would be nice if we could find investments that have little to no risks. Unfortunately that is not the how the risk/reward relationship works. You must be aware of these risks, especially if you are investing in individual bonds.
Luckily you can invest in diversified bond funds that spread many of these risks out for you. You can also decrease your risk by investing in certain types of bond funds by avoiding or decreasing certain risk factors.
In part 4 of my series on bonds I will go over the use of bond funds in your portfolio.