The last edition of Sound Views was focused on various types of cash investments. You can think about the universe of investments as a spectrum where cash is at one end and risky investments like emerging market stocks and non-traditional investments are at the other. In this respect, cash alternatives form the most basic building block of an investment portfolio and should be used to meet daily living needs as well as any short or intermediate major expenses (think a new car or an upcoming wedding). This edition of Sound Views will focus on the next investment category on the spectrum, Fixed Income/ Bonds.
At its most basic form, fixed income investing typically involves a promise that one party will pay a fixed rate to another party over a specified period. This represents a form of debt. One of the most common examples of this in everyday life is a mortgage, where a borrower takes out a fixed rate and pays it back over the life of the mortgage. In the investment world a “straight bond” is one that has a fixed interest rate and a fixed maturity date, and no options for early redemption beforehand. Straight bonds can easily be valued because they have a known predictable payment schedule unless the issuer goes bankrupt. This brings us to our next point, bond risks.
Virtually all bonds, and fixed income investments in general, are priced based on their time left to maturity and the probability that the issuer of the bond will make their payments on time. These are called term or interest (rate) risk and credit risk respectively.
Bonds and fixed income investments are generally priced based on:
- Time left to maturity (Risk = Term or Interest Rate Risk)
- Probability the issuer of the bond will make their payments on time (Risk = Credit Risk)
Term or Interest Rate Risk
Treasury bonds are often thought of as low risk or even risk free, but they are subject to interest rate risk. Putting the debt ceiling debate aside, assuming the US government does not default on its debts, the first risk of treasuries comes from rates going up while you hold them. The other risk, is that you choose a shorter term and rates are lower when your investment matures if you want to reinvest. To give a specific example, if a 3-year bond is paying 5% today but in 6 months a 2.5 year bond will pay 7%, you might be better off waiting to buy it. If you bought a 6-month bond paying 5% hoping that in 6 months’ time you can reinvest in a 2.5 year bond that pays a higher rate but now rates are 4%, you missed an opportunity to lock in the 5% over the full term. It can be very tricky to time interest rates and having a sensible approach can help avoid some of the pitfalls investors face.
Credit Rate Risk
Outside of treasuries we run into credit risk and what are known as credit spreads. The term spread means the additional interest you receive on a bond above the “risk-free” treasury rate. There are different grades of risky bonds ranging from very high-quality investment grade to speculative rated junk or high yield bonds. Typically, the riskier the bond the higher the spread you receive to compensate you for the risk you’re taking.
While they seem simple, bonds can get increasingly complex from here. There are investments that pay rates that float or that don’t have a fixed maturity date. The mortgage example earlier can be like this because most people don’t take a full 30 years to pay down their mortgage. There are bonds where the issuer can call them away from you and some circumstances where you can force the issuer to buy them back. Municipal bonds are another form of fixed income where the interest may be federally and state tax free, but carry their own types of risks. Finally, there are some bonds that trade more like equities and even stocks that trade more like bonds (preferred stocks).
Given all the nuances of the fixed income market, it can be difficult for investors to navigate. Knowing how these investments behave can be critical to your success through different environments. Many investors who seek to have lower day-to-day volatility in their portfolios will own large amounts of fixed income, but just because they don’t move around as much as stocks doesn’t mean bonds are completely risk free. A professionally managed bond portfolio can help address these risks as they come. As always, reach out to your advisor if you have further questions on this topic.