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