Bond markets are complex, and if investors aren't aware of the different types of risks that affect a bond's value, their investments can lose money.
Fixed-income investors take two primary types of risk: interest-rate risk and credit risk, and in exchange, buyers get a return. These two forms of risk can be interrelated, but they also represent different facets of a bond's value:
- What is an interest-rate risk?
- What is credit risk
- How these factors affect current market conditions
What is an interest-rate risk?
Investors take on interest-rate risk when they purchase a bond with a certain yield. There is a "chance that once you purchase an investment, interest rates will rise or fall, making the value of that investment worth more or less than when you purchased it," says Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott.
The Federal Reserve sets short-term interest rates and will raise or lower them based on economic conditions to keep inflation low. The Fed has a 2% inflation target, and if inflation remains under that level, the central bank can keep rates low. If inflation seems to be rising too fast or is holding above the Fed's target, the central bank will raise rates.
When interest rates increase, the price of bonds falls because bond yields and bond prices move inversely to keep the value constant. Interest rates may increase on their own for a few reasons, says Bill Zox, chief investment officer, fixed income and portfolio manager at Diamond Hill Capital Management.
Inflation might be rising faster than expected, or investors may demand more after-inflation return from their bond investments. This is known as the real yield.
"It's basically inflation expectations plus the real yield gives you your bond yield," Zox says.
Normally, if inflation expectations increase or investors demand more return from their bond investments, it's because the economy is strong. A strong economy usually leads to faster earnings growth, which should be good for equities.
"In a normal environment, if interest rates are increasing, the value of bonds should be decreasing and the value of stock investments should be increasing," Zox says.
Interest rates are higher for bonds with longer maturity dates.
Maturity can be as short as a day or as long as 30 years or more, in some cases. Jason Ware, head of municipal bond trading at 280 CapMarkets, says investors can tailor how they want to expose their capital to interest-rate risk by holding bonds with different maturities.
"The shorter the timeline is, the faster you're going to get that principal back, and you are a little less susceptible to some of that interest-rate risk," Ware says.
What is credit risk
Credit risk is the chance that a bond issuer, the borrower, won't perform its legal obligations to pay back the debt, LeBas says.
Ware says people can think of credit risk like a credit score for companies. Companies with low credit risk are not unlike people with high credit scores. Both can borrow money from banks at lower interest rates because they're less likely to default.
When companies decide on a yield for the bonds they want to sell, they start with the benchmark interest rate, and then add more yield entice investors. That differential is known as a credit spread, and the benchmark interest rate is Treasury bonds.
Companies that have a high risk of defaulting must offer buyers a yield high enough to make the return worth with the risk. These are known as high-yield or junk bonds.
"Unlike equity managers, if you're a bond manager, the best thing that can happen is you get your money back. When you look at credit risk, you know you are being compensated for the probability that you will not get your money back," says Jeffrey MacDonald, head of fixed-income strategies at Fiduciary Trust International.
How these factors affect current market conditions
Interest-rate risk influenced stock and bond market direction in 2018, when rates increased and both markets fell.
In 2019, rates fell and both markets rose.
For 2020, Zox says the key question is whether economic and earnings growth validates 2019's strong moves in both stocks and bonds. Earnings didn't grow much in 2019, but if earnings grow 5% to 10% this year, then, "stocks will do reasonably well, but nothing like 2019," he says.
That could cause interest rates to increase and bonds may struggle to produce positive returns, he adds.
If earnings don't materialize and defaults increase in 2020, then government and high-quality bonds may do well and interest rates will come down from current levels, Zox says.
"Equities and high-yield bonds, in particular, will struggle because the risk of recession will be higher and the risk of corporate defaults will be higher," he says.
There's always a tradeoff between what the level of interest or credit risk an investor will accept, LeBas says.
He says with solid economic conditions and corporate profitability, investors aren't getting paid to take a lot of risks, which is why credit risk is low and credit spreads between the safest and riskiest bonds are tight.
For a point of reference, currently, the average high-yield bond is paying about 3.27% over the U.S. 10-year Treasury bond yield. While that sounds high, he says over the last five years the risk premium been as high as 8.4%.
LeBas says his firm recommends clients own higher-quality bonds with intermediate to longer terms, which he defines as five to 15 years. Since the Fed has said it will likely keep interest rates low for the foreseeable future, he believes having longer-dated bonds is a good way to hedge against potential stock market weakness.
"At a time when stock market valuations are high, a good way to buy a portfolio is to own longer-term bonds," he says. "If (stock) valuations fall – that's not our prediction – but if valuations fall, then those long-term bonds will generally perform well."
MacDonald prefers to take credit risk rather than interest-rate risk because he believes longer-dated maturities don't have enough yield to compensate investors versus shorter-duration vehicles.
"You can look at company fundamentals and say they're solid enough so that the idea of a big wave or surge of defaults given the economic backdrop seems unlikely," he says.
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