October 13, 2010

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Fixed Income Risk in Your Portfolio

With interest rates near historical lows, some investors may be anxious about a possible rate climb and its potential impact on their fixed income investments.  Rising interest rates typically cause existing bonds to lose value.  While investors might hold short-term instruments to manage this risk, an interest rate decline could spoil this strategy by forcing investors to reinvest in lower yields when their short-term instruments mature.

Rate movements in either direction affect portfolio returns.  This is true in any market environment, regardless of the current rate level.  The larger question is how to manage the risk.  As you read the financial headlines and evaluate your current fixed income exposure, it may be helpful to consider these principles about fixed income investing:

Interest rate movements are unpredictable.
Academic research offers strong evidence that the bond market is efficient, and that bond prices and interest rates are not predictable over the short term.  This uncertainty is reflected in the often-contradictory interest rate forecasts offered by economists, analysts, and other market watchers.

Even when the experts share similar views on the direction of the economy and credit markets, reality often proves them wrong.  Last year’s Wall Street Journal forecasting survey offers a recent example.  Among 50 economic forecasters surveyed in 2009, 43 expected the ten-year US Treasury note yield to move higher over the next year, with an average estimate of a 4.13% yield.  Only two respondents predicted rates to fall below 3.00%.  The ten-year Treasury yield slumped to 2.95% on June 30, 2010, and rates on thirty-year mortgages fell to their lowest level since Fannie Mae began tracking them in 1971.

Today’s bond prices already reflect expectations for tomorrow’s business conditions and inflation, and these expectations can change quickly in response to new information.  This new information is unknowable.  Investors who accept market efficiency should not be surprised when the credit markets foil the experts.  If prices were easy to forecast, you would find a host of fixed income managers with market-beating returns.  But most of them underperform their respective benchmarks over longer time periods.

Since no one has a reliable method for determining whether interest rates will rise or fall in the near future, investors should avoid making fixed income decisions based on a forecast, media coverage, or their own hunches.

Pursuing higher expected returns requires more risk taking.
The strong link between risk and return appears in all properly functioning capital markets.  When investing in stocks, bonds, or other assets, investors must accept more risk to pursue a higher potential return.

In the fixed income markets, earning a return above short-term government instruments is usually a function of assuming more term and credit risk.  Term risk refers to a bond’s maturity, and credit risk refers to the creditworthiness or default potential of the borrower.  Bonds with longer maturities and lower credit quality are usually considered riskier and have offered higher yields and returns to compensate investors for higher risk.

On the term side, investors who commit their capital for longer periods of time are exposed to the amplified effects of changing interest rates.  Bond prices and interest rates move in the opposite direction:  When rates rise, the value of an existing bond declines; when rates fall, bond values rise.  The market adjusts the price to match the yield available on a new instrument.  The longer the bond’s maturity, the greater the price adjustment for a particular interest rate change.

On the credit risk side, the Government is considered the strongest borrower in the market, so it has a lower cost of capital relative to other issuers.  The most creditworthy companies are considered relatively safe, but they must still offer a higher rate than the Government to compensate investors for taking more default risk.  The weaker a corporate borrower’s financial condition, the more it must pay in yield to attract investors.  Investors seeking higher returns on the credit spectrum must bear a higher risk of default.

Investment strategy should drive fixed income decisions.
Investors may hold fixed income securities for a variety of reasons—for example, to reduce portfolio volatility, generate income, maintain liquidity, pursue higher returns, or meet a future funding obligation.  Each objective may involve a different portfolio approach, or a combination of strategies to manage tradeoffs.  Regardless of your approach, you should know the difference between controlling risk and avoiding it.  You cannot eliminate risk, but you can manage your exposure by diversifying across maturities, industries, countries, and currencies to reduce the impact of rates, inflation, currency fluctuations, and other risks.

Many factors influence the direction of interest rates and performance in the bond markets, and these are too complex for anyone to reliably predict.  Rather than placing your faith in the experts or reacting to economic news, manage your fixed income component from a portfolio perspective.  Your strategy should reflect your overall investment goals, risk tolerance, and other personal financial considerations.  This is a solid approach to managing your portfolio in an uncertain interest rate market.

Over the long term, it’s interest income—and the reinvestment of that income—that accounts for the largest portion of total returns for many bond funds.  The impact of price fluctuations can be more than offset by staying invested and reinvesting income, even if the future is similar to the rising-rate environment of the late 1970s and early 1980s.

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