By: Frank Armstrong
*As seen on Forbes.
When we look at fixed income investments, bonds, CDs, or other instruments which pay income and promise a return of capital at some point in the future, risk varies with the duration of the bond, and its credit rating.
When you buy a bond, you are simply lending money to a government or corporation. The bond will pay you interest, generally twice a year, and upon maturity will return its face amount.
Bonds are issued at par, and redeemed at par. Along the way as interest rates in the economy change or the perceived risk of default for the instrument changes, the value of the bond will fluctuate. The best case for a bond is that it will pay its interest and return the face amount on time. As opposed to stock (equity) no matter how successful the enterprise, bonds will not share in the profits.
We generally assume that there is no default risk with US Treasury obligations, and virtually no interest rate risk because they will very shortly roll over to par. But a long duration bond of 20 to 30 years can be very volatile as interest rates change. Investors that must sell prior to maturity could endure substantial losses if interest rates had increased during their holding period.
As an example, suppose you had purchased a $10,000 25 year government bond at a 4.5% interest rate, but suddenly interest rates rise 1%. No one would pay full price for your bond when they could buy another bond at the current rate. So, to unload your bond you must discount the price until the purchaser has a 5.5% return on the bond if he holds it to maturity. Your bond is now worth $8650.10. Ouch, that hurts.
Of course, if interest rates had fallen in our example, the bond would have increased in value. With interest rates scraping along at close to zero today, there isn’t much room for them to fall. On the other hand, there is lots of room for rates to increase, so bonds offer plenty of downside, with little upside at today’s interest rates.
Some investors may take the position that if they hold to maturity there is no risk. But, let’s not kid ourselves. They are refusing to recognize a real loss and if they had their original $10,000 in their hands they would be much better off.
Because discounting is an exponential process, the longer the periods until maturity, the higher the principle fluctuations as interest rates change. If your bond is about to mature in 30 days, even large interest rate changes in the market will have very little impact on your bond’s value. But, if you are on the other end of the spectrum with a 30 years bond, tiny interest rate changes will whipsaw your bonds value.
Because they offer little risk of either default or duration, the 30 Day Treasury is considered the zero risk asset class against which all other assets may be measured. For any other higher level of risk, investors will demand a higher return. The difference in returns between the zero risk asset class and the other investment opportunity is the premium investors demand for the additional risk.
As you might expect, investors would generally demand a higher return for longer periods. So, that’s what we normally see. When longer term bonds have a higher return than shorter bonds the yield curve is said to be positive.
Federal Reserve Policy
The bond market is heavily influenced by Federal Reserve policy. In “normal” times, the Federal Reserve adjusts short term rates and long term rates are set by demand-supply in the market driven mainly by inflation expectations. But, not always. The Fed might massively buy longer term bonds thereby driving up their prices and reducing yields. They tinkered with the bond market most recently to promote economic recovery after the near meltdown of 2008-2009. If they are able to drive longer term rates below shorter term rates, then the yield curve is negative.
Today all interest rates are very low, and in some cases approaching zero. It’s tempting to chase yields by extending the duration of the bond portfolio. But, investors do so at their peril. Volatility and the chance of painful economic loss increase much faster than returns at longer periods. At the long end of the spectrum risk can approach that of the stock market for very little increase in returns. After all, if you are going to take risk, take it where you expect reasonable compensation. In this case, long term bonds are not attractive. So, most of us should resist that temptation and keep duration on the short end of the spectrum. So, most of us should resist that temptation and keep duration on the short end of the spectrum.
There is a reasonable increase in returns between the 30 day Treasury and a Two Year Treasury after which risk rises so sharply that the tradeoff is unfavorable for investors seeking an optimized risk return position.
However, institutions that need for regulatory purposes or prudence like insurance companies and pensions may choose to match future liabilities with bonds maturing about the same time as the liabilities. For instance, if you are an insurance company with expected death claims of $100,000,000 fifteen years from now, you could buy an equal amount of bonds that mature in fifteen years. So, funds would be available at the time claims need to be paid with little or no risk. If you are not an insurance company, perhaps you should pass on that 20 year bond.
Credit risk is the other driver of returns in the bond market. Bonds with a higher risk of default vary more than those with low default risks. So, investors will demand a higher return. It follows that corporate and government bonds not backed by the full faith and credit of a sovereign credit worthy nation carry proportionally higher coupons which may be attractive to many investors. But, as you might expect volatility well be somewhat higher for even the most credit worthy companies and even higher still for the junk bond category. Again, the returns are not high enough to justify the risk for many bond issues, and investors are well advised to temper their enthusiasm for junk. If you are going to take an equity like risk, you should invest where you will be compensated for it.
The take away from examining returns from bonds is that the premiums are most directly attributed to duration and credit risks.
I’ll have more to say about bonds and how they are priced and traded before we move on to equities.