Risks Associated with Fixed Income Investing

Posted by The Dopkins Wealth Team | Mar 27, 2015 11:33:00 AM

Q: What are the risks associated with fixed income investing?

A: Following is a brief overview of each of the primary risks associated with investing in fixed incomemunicipal-bond

Interest rate risk is when your bonds’ values fall as a result of an increase in interest rates. This risk generally increases with maturity; longer-term bonds have substantially more interest rate risk than short-term bonds. Over the period 1964–2013, the standard deviation of the returns of long-term bonds bears out the presence of heightened interest rate risk as maturity is extended:

 

 

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Reinvestment risk occurs when future interest and principal payments will not be reinvested at the prevailing interest rate that the bond was initially purchased. This risk generally decreases as you extend maturities. Reinvestment risk is in direct conflict with interest rate risk, so eliminating one amplifies the other. A well-structured bond ladder is an effective way to balance these competing risks.

Inflation risk happens when bond returns are eroded by inflation. Generally, inflation risk is higher as bond maturity increases. For example, a 30-year Treasury bond might yield 4 percent. If inflation averaged 6 percent per year over the next 30 years, then you would have lost 2 percent per year in real (or net-of-inflation) terms. Even short-term bonds can have exposure to inflation risk because their returns have barely outpaced inflation historically, and they are not a perfect inflation hedge. TIPS are the only securities that are generally guaranteed to outpace inflation (at least on a pretax basis).

Liquidity risk is generally thought of as the cost of getting out of a position. It does not usually mean a total inability to liquidate a security. Also, all else equal, yields on illiquid bonds are generally higher than yields on liquid bonds. Treasuries are considered to be the most liquid securities. Investors can move in and out of Treasuries and pay very little in transaction costs. Agencies, municipals and brokered CDs are less liquid. Liquidity risk also tends to be correlated with credit risk. So when credit risk is increasing, liquidity risk tends to be increasing as well.

Historically, U.S. Treasury bonds have been viewed as the only fixed income security with no credit risk. Investing in anything else means you are taking some credit risk. A rule of thumb for the amount of default risk you are taking is the spread on the bond versus Treasury bonds. One popular yet simplistic model is to treat the spread as the one-year probability of that issuer defaulting, so a bond trading at a spread of 1 percent has a 1 percent probability of defaulting over the next year.

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Sources: One-Year Treasuries, Bank of America Merrill Lynch, 1-Year US Treasury Note Index; Five-Year Treasuries and Long-Term Government  Notes, Morningstar.                    

Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

 

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Topics: fixed income, investing,, reinvestment risk, liquidity risk, inflation risk, interest risk

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The Dopkins Wealth Team Dopkins Wealth Management (DWM) is an investment advisory and consulting firm that specializes in providing comprehensive wealth management services by incorporating tax planning, business succession planning, wealth preservation, and wealth transfer into our investment strategies and fiduciary-based solutions. Whether it’s an individual, institutional investor, Corporate 401k plan, foundation or endowment, our clients benefit from our use of an investment strategy grounded in academic research that focuses on long-term success. The key to our client’s success is our ability to understand their unique financial goals and needs, and integrate that with their need, ability, and willingness to take risk to formulate a long-term plan for financial security and prosperity. For more information, contact Tom Emmerling at temmerling@dopkins.com.

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