We are in an unusual time in history where the traditional views on the safety and conservatism of bonds may no longer be viable.
Traditionally, fixed-income securities, or bonds, fall on the conservative side of the risk spectrum. Ask any investment professional to show you the typical allocation for a conservative investor and he or she will likely display a pie chart with a large slice of the pie designated for fixed income investments.
Corporate bonds are considered safer than stocks because they have liquidation and cash flow preferences to stockholders; and the tradeoff is that they also have limited upside potential, unlike stocks.
U.S government bonds are considered safer than corporate bonds because they are backed by the federal government.
Q Besides a default, how do bonds lose their value?
A Bond prices move in the opposite direction of interest rates. If you hold a bond that is earning 4 percent and interest rates rise, new issues of bonds with the same risk characteristics of the bond that you hold might earn 5 percent.
Now you are underpaid for your risk. For you to sell the bond, you must offer it to another investor at a discount, which mean you will have a loss of principal. You get your principal back if you hold your bond until maturity, but you incur an opportunity cost by waiting it out, earning a lower-than-market rate.
The risk is even greater for those who hold bond mutual funds. Investors that own shares of a bond mutual fund have the same interest rate risk exposure, but unlike direct owners of bonds, cannot hold the bond until maturity to prevent a loss of principal.
Since the financial turmoil that occurred in 2008, interest rates have been in a range that we have not seen in nearly 50 years. The 30-year Treasury bond has not fallen below 4.4 percent, where it was on Dec. 31, 2010, since the mid-1960s.
Interest rates have begun to creep up as the economy has recently shown signs of recovery, such as the recent drop in unemployment. Many economists believe that inflation could be a risk in the future as a result of the Fed's past actions to stimulate the economy.
With inflation comes rising rates, and with rising rates comes a challenging market for bond investors.
Investment advisers find themselves in a tricky spot as they seek to find appropriate investments for clients who primarily need to preserve their wealth and generate current income.
Bonds and bond mutual funds are traditionally the vehicles that provide such benefits. However, a steady increase in interest rates will certainly cause accounts loaded with fixed income investments to lose their value.
Investors who want the least risk may be at a high risk for loss, and to make things worse, they are getting paid relatively little for taking on the risk.
It's hard to make up losses in a bond portfolio. Unlike the stock market which is up almost 100 percent since its low in March of 2009, losses in bonds can take many years to recover, if they recover at all.
Q How is interest rate risk measured?
A Interest rate risk is measured by duration. Typically the longer until the bond's maturity, the longer the duration and the more it will decline in value when rates rise. Bonds with a higher duration often pay a higher interest rate to compensate the investor for taking on more interest rate risk.
Can you find bonds that pay a higher rate with lower relative duration? You sure can; they are called junk or high-yield bonds. These bonds are issued by companies that are less financially sound as investment-grade bonds. They pay a higher yield with less duration, but have more credit risk. So in essence, if you are determined to stay in fixed income securities, you must determine the greater risk -- rising rates or corporate defaults.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken, CFA, is vice president of investments with DeMoss Capital -- demosscapital.com. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at firstname.lastname@example.org.
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