No Free Lunch: BONDS

Bonds

Interest-rate risk:  Interest rate risk is the chance that interest rates will increase thereby pushing down the prices of already-existing bonds with lower yields attached to them.  The longer the duration of a bond portfolio, the more vulnerable it will tend to be to interest-rate increases.  That’s because not only will investors in the long-duration bond be stuck holding a lower-yielding asset when rates increase, but they will be forced to hold onto it for a longer period of time, increasing their opportunity costs.  Investors can mitigate interest-rate risk somewhat by holding individual bonds until maturity, but it can be difficult for smaller investors to build well-diversified portfolios composed of individual bonds.  This article discusses how to use duration to help assess the extent to which interest-rate sensitivity is embedded in your bond funds.

Credit risk:  Credit risk is the possibility that a bond issuer will be unable to pay its debts.  To help make up for this risk, bond issuers with lower credit qualities typically must pay their bondholders higher yields than high-quality firms issuing bonds of the same duration.  Default risk isn’t the only reason that holders of lower-quality credits can run into trouble: In periods of economic hardship, such as the 2008 financial crises, investors often sell out of low quality bonds pre-emptively, thereby depressing their prices.

Inflation:  As with cash, investors earning a fixed yield on their bond investments will see a decline in their real, take-home yields as prices increase.  Treasury Inflation-Protected Securities or TIPS and I-bonds include an inflation adjustment on top of the yields the bonds offer, thus effectively removing this risk for bondholders.

Reinvestment risk:  Reinvestment risk generally consists of the threat that the holder of a security will be forced to reinvest in a less attractive security or environment than the one they had originally.  For bondholders, this is the risk that bond issuers will refinance their obligations in an effort to lower their interest payments, thereby leaving the bondholder to reinvest the money in a lower-yielding environment.  Reinvestment risk has been on full display in the past few years, as many bond issuers have called those of their bonds featuring higher yields.

Foreign Bonds

Currency risk:  Holders of foreign bonds hold all the risks outlined above but they may also face a few additional risks factors.  One of the most notable is currency risk – the chance that the currency in which the bond is denominated falls relative to the investor’s home currency, thereby reducing or even wiping out any appreciation from the bond itself over the investor’s holding period.  Some foreign-bond funds hedge their currency exposures to essentially wipe out the effects of currency fluctuations on returns, hence reducing volatility and making returns more bond-like.   

Geo-political risk:  Foreign-bondholders may also see their bonds’ prices drop due to geopolitical concerns – for example, political unrest in the country in which an issuer is domiciled.  Even if investors in such bonds don’t believe that a default is imminent, other investors may demand a higher yield from the bonds to make the risks worth taking, thereby driving down the bonds’ prices.

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