Navigating the Fixed Income Waters
Given the downward plunge in equity markets that started at the beginning of 2008, investors have flocked to fixed income options in droves. But buyers should beware. Swimming in the fixed income markets is not like frolicking around in the kiddy pool, but rather more like swimming in treacherous, crocodile-infested waters. Not all bonds are created equally, so arming yourself with knowledge regarding bond investing risks can save lots of money (and limbs).
Bond prices move in the inverse direction of interest rates – so now that interest rates have fallen to five-decade lows, is now the best time to buy bonds? Certainly there are segments of the bond market that offer tremendous value, but when the Federal Funds Rate (the key benchmark inter-bank lending rate that the Federal Reserve sets) stands at effectively 0%, that means there is only one regrettable direction for rates to go.
Before diving head first into the bond market, investors should educate themselves about the following risks:
Interest Rate Risk: With record low interest rates, coupled with massive amounts of government stimulus injected both here and abroad, the risk of rising interest rates is becoming a larger reality. Large government deficits and expanding government debt issuance can lead to inflation pressures that are correlated to upward movements in interest rates.
Default Risk: Bonds typically pay bondholders interest payments (coupons) until maturity (expiration), however in challenging financial times, various issuing entities may be incapable of paying its investors, and therefore may default. As the recession matures, more and more companies are defaulting on their debt obligations.
Reinvestment Risk: Owning healthy yielding bonds in a declining interest rate environment is the equivalent of sailing with a tailwind – however all good things must eventually come to an end. At maturity, investors must also face the risk of potentially reallocating proceeds into lower yielding (lower coupon) alternatives. For those investors relying on higher fixed income payments to cover living expenses, reinvestment risk can pose a real threat to their financial future.
Callable Risk: Just like ice cream comes in different flavors, so do bonds. Certain bonds come equipped with an add-on “callable” feature that allows the issuer to retake possession of the bond for a predetermined price. In periods of declining interest rates, as we have experienced since the early 1980s, this advantageous option has been included repeatedly by many bond issuing entities. Prepayment risk for mortgage securities can also lead to suboptimal investment returns.
Liquidity Risks: This whole banking crisis that our global financial system is currently digesting has highlighted the importance of liquidity, and the painful clogging effects of illiquid fixed income securities. Forced sales of illiquid securities (due to lack of buyers) can lead to unanticipated and drastically low proceeds for sellers.
Overall, bonds offer tremendous diversification benefits to an investment portfolio and with the exploding baby boom generation entering retirement these fixed income vehicles are attractive. Just remember, before you dip that toe into the bond market waters, beware of the lurking risks hiding below the surface.