When it Comes to Bonds, Chasing Yield Can Be Hazardous
Interest rates have remained low for such an extended period that some of the most conservative investors and fund managers have had to search beyond safer government bonds to get the income they need. There are generally two ways to obtain a higher yield with bonds:
- Use longer-term bonds (increase the interest rate risk)
- Use lower quality bonds (increase the credit risk)
So how do you assess these two risks embedded in your bonds or bond funds?
For Interest Rate Risk, Look at “Duration”
When interest rates increase, the value of your bonds will decrease – but by how much? Measured in years, duration is a simple way to estimate how much this decrease will be. For example, if your bond fund has a duration of 5 years, and interest rates quickly increase by 1%: The value of your fund will go down approximately 5%. A duration of 2 years would see a drop of 2%, and so on.
The duration statistic is easy to find for mutual funds and ETFs; but for individual bonds, you may need to request this information from your bond specialist or advisor. Finally, it’s important to note that this statistic should be used for estimates of interest rate risk and it is a less useful measure for large changes in interest rates or lower quality bonds.
For Credit Risk, Look Beyond “Average Credit Quality”
Credit risk can come in several different flavors so it is important to look beyond the average credit quality of a bond fund, or the particular rating of a bond. Seeking higher yields, general bond managers may add junk (lower than BBB rated), non-rated, mortgage-backed, bank loans, or other types of debt. You will want to review your holdings to uncover any concentrations in these areas.
Knowing what you own will help you determine your exposure to economic events and manager risk. In general, low quality bonds will act more like stocks – prices may vary widely and actually move in the same direction as stock markets. If your general bond portfolio has more than an incidental amount of holdings in specialty areas such as emerging market or junk bonds, be sure that your advisor has the ability and resources to manage these holdings over time.
The High Yield Hazard
Although it is tempting to seek higher yield bonds to meet your income needs, you have to know how this yield is being achieved and how much safety you are giving up. Otherwise, you may be surprised by your results as economic news and market events unfold.