The adage that there is no free lunch is quite germane in the realm of fixed income investments: the greater the return, the greater the risk. With money market accounts yielding next to nothing, 5-year treasury bonds offering about 2%, and bank CDs something in between, you are probably tempted to reach for more yield. In your quest for alternatives, you are wise to understand why one security yields more than another. You can avoid mistakes, and unforeseen loss.
Avoid Bond Funds
First and foremost, whatever sector of the fixed income market you choose, at this point you should avoid bond mutual funds. When you buy a bond directly, if you hold the bond to maturity you will in fact earn the yield to maturity presented at the time of purchase. The price of the bond may vary over time, but at maturity you will receive par – the face amount of the bond.
Such is not the case with mutual funds. As bond prices go up and down, so too do the prices of mutual funds that invest in bonds. Funds do not mature.
There is widespread belief that interest rates are going to rise in the near future. From current levels, a 1% rise in the yield on 5-year bonds would cause a price drop of about 4.6%. A 1%r rise in 10-year bond yields would cause an 8% price drop. Bond fund share prices will reflect these losses. Does it make sense reaching for an extra one or two percent in income only to lose twice that, or more, in principal?
Don’t Accept Lower Credit Standards
One way you could attempt to earn more is by investing in high yield bonds, also known as junk bonds. These are securities issued by companies whose weak financial characteristics or deteriorating prospects earn them a less-than-investment grade credit rating by firms such as Standard & Poor’s or Moody’s. The bonds are considered speculative and therefore a higher rate of interest must be paid to entice investors who might otherwise choose safer investment grade bonds or even credit-risk-free treasury securities.
| S&P Rating Category | Cumulative Default Rate |
| AAA | 0.6% |
| AA | 1.5% |
| A | 2.91% |
| BBB | 10.29% |
| BB | 29.93% |
| B | 53.72% |
| CCC-C | 69.19% |
| Investment Grade | 4.14% |
| Non-investment Grade | 42.35% |
| All | 12.98% |
In addition to offering a higher rate of interest, junk bonds unfortunately entail higher default rates. Default is when a bond issuer does not make a due payment for interest or principal. Upon default a bond will lose much, and perhaps all, of its value. Despite misleading rosy short-term surveys cited by brokers, long term studies by the ratings agencies indicate cumulative default rates of nearly 30% for bonds rated BB, the “best” junk bond rating. Defaults are far worse for lower rated issuers.
Junk bonds are effectively loans to less than worthy borrowers. Is this where you want to invest the “safe” part of your portfolio?
Don’t Extend Maturity
One can increase yield without hurting credit standards by simply buying bonds of longer maturity. Such bonds currently, and usually, yield more than short term securities due to increased risk. These bonds will be outstanding during more years in which events of unknown effect will occur. Also, mathematically a given rate change will have a bigger price impact on bonds of longer terms. Note the earlier example of a 1% rate rise causing price declines of 4.6% and 8% for 5- and 10-year maturities. More examples are in the accompanying table.
| 5-Year Treasury |
10-Year Treasury |
20-Year Treasury |
|
| Current Rate | 2.14% | 3.5% | 4.34% |
| 50 year average rate | 6.49% | 6.76% | 6.80% |
| 50 year high | 15.93% | 15.32% | 15.13% |
| 50 year low | 1.18% | 2.42% | 3.18% |
| Principal loss if rates rise 1% | 4.6% | 8.0% | 12.2% |
| Principal loss if rates return to their average level | 18.3% | 23.4% | 26.7% |
Currently, rates sit near an all time low, the Federal Reserve is printing money like never before, and the government continues to borrow over a trillion new dollars annually. With increased demand for capital abroad and within our somewhat re-energized economy, rates are very likely to go up, and bond prices down. How much, or when, is anyone’s guess. No doubt, though, longer term bonds have a greater chance of experiencing that decline, and that decline will be more dramatic the longer the term.
Keep Bond Holdings Direct, Good, and Short
If you are already invested in bond funds, especially those with average maturities greater than a year or two, you might consider selling. Similarly, if you own junk bonds of any maturity, or bonds of any credit rating with maturities greater than 5-years or so, you might consider seeking good bids through your brokerage platform and hitting such. Among assets you are allocating within the fixed income sector, consider keeping your money in cash equivalents, FDIC insured CDs maturing in less than 3 years, and/or high-grade corporate bonds maturing in less than 5 years. Depending on your mix, you can lock in 2% to 3%, put your risk of loss near nil, and maintain the ability to efficiently redeploy assets. If you are uncomfortable selecting securities on your own, you can seek assistance at your financial institution or through a registered investment advisor.
In bonds, patience is currently a virtue. Bonds should represent the safe portion of your portfolio. Stocks, commodities, land, and other volatile investments are instruments with which you should expect higher risk and aim for higher expected returns. If you seek better potential performance and can accept greater uncertainty, then consider reallocating a portion of assets currently in fixed income into stocks. You could even increase cash income as many equities currently have dividend yields higher than similar quality bonds.
The fixed income arena currently offers minimal returns for which you should only accept minimal risk. It is not worth reaching for 1%, 2%, or even 3% of extra yield if you add downside price prospects many times greater.
This article was originally published in a special edition of the Princeton Packet in January 2011.
