Most investors will admit that they have themselves, or know someone, that has refinanced their home mortgage in the last six years because interest rates were so low. The financial media has led average investors to believe that interest rates are so low that there is no other direction but higher. In the face of what many consider obvious, investors are warned about the negative effect of rising rates on bond prices and the need to avoid the asset class completely. So before investors abandon bonds, let’s look at the risks are and how best to manage them.
Bonds are considered to be a safe haven for investors because of investment features which provide steady predictable payment of principal and interest with protections that equities do not possess.
However, bond investors are still subject to investment risks which include:
- Default Risk – payments not made as promised.
- Call Risk – return of principal made when prevailing market interest rates are low.
- Reinvestment Risk – interest payments reinvested at lower rates than yield-to-maturity.
- Price Risk – bond prices inversely correlated with interest rates.
Default and call risks cannot be eliminated. However, reinvestment risk and price risk can be virtually be eliminated by selecting appropriate bond lives. Reinvestment rate risk and price risk both arise from uncertainty about future interest rates. In fact, both risks are aspects of a more basic risk: interest rate risk. It is important to note, that the impact of a change in interest rates works in opposite directions on bond prices. The economic observations of bond price behavior, as a result of reinvestment and price risks, has led to the financial analysts’ development of the calculation of a bond’s duration which is the average weighted date that cash flows are received. A bond or bond fund’s duration can help investors to balance these risks as discussed below.
If interest rates increase, reinvestment income increases whereas bond prices decline. Conversely, a reduction in interest rates causes reinvestment income to decline and bond prices to increase. Since the two forces move in opposite directions, it is possible for the favorable impacts of one to exactly offset the unfavorable impacts of the other. This is the basic concept behind duration calculations which immunize, or protect, a fixed income portfolio against interest rate risk.
Bond investors can manage risks associated with changes in interest rates by selecting bond portfolios with durations that match the average weighted date that they need the proceeds from a bond or bond fund sale. As a matter of empirical reference, default and call risk can be mitigated through the following rule of thumb; lower credit quality bonds perform better than higher credit quality bonds with similar maturities during periods of rising interest rates.
The fact that reinvestment risk and price risk can offset each other by proper selection of bonds with the appropriate duration is not fully understood by most investors and is an important area of investment management for which financial advice should be sought. This is especially true during periods of anticipated interest rate increases.
