In this series, we’ll continue our discussion from the series Investing in fixed income: What motivates bond investors?, which we published yesterday. In the last part of that series, we discussed one of the most important concepts in fixed income investing: the yield curve, which shows yields for bonds of different maturities and a similar credit quality. We also discussed how the Fed’s yield curve can impact returns on the portfolios of both retail and institutional investors. In this article, we’ll discuss some of the risks prevalent in bond investing that investors should be wary of.
What is interest rate risk?
“Interest rate risk” refers to changes in a portfolio’s bond prices due to shifts in the yield curve. As we mentioned earlier, the yield curve is a graph that plots interest rates at different maturities with the same credit quality that can range from a month to 30 years or more. Shifts in the yield curve occur when there are changes in yields for the different maturities. These changes may be different for the different maturities plotted. Changes in yields cause changes in the prices of fixed income securities. An increase in yield corresponds to a decrease in price, and vice versa. For a detailed explanation of the yield curve, see this article from a related series, Understanding the Fed’s yield curve can impact your bond returns.
Under normal circumstances, the yield curve is upward-sloping which means longer-term maturities have higher yields and therefore higher durations. Duration is the sensitivity of a bond’s price to small parallel shifts in the yield curve. Duration for a portfolio or a bond is primarily affected by the coupon, yield, and time-to-maturity. Other things remaining constant:
- The higher the coupon, the lower the duration, and vice versa
- The higher the yield, the lower the duration, and vice versa
- The higher the time-to-maturity, the higher the duration, and vice versa
So we can infer that interest rate risk is higher in low-coupon and zero-coupon (ZROZ), lower-yield, and longer-term bonds (TLT). This is because not only does the bond’s duration increase as yield decreases, but also the bond’s lower coupon provides less of a cushion to offset principal losses should the investor’s holding period be less than maturity. So an index composed of short-term (BSV) or intermediate-term bonds (VCIT) is more appropriate as a benchmark for risk-averse investors.
ETFs investing in zero-coupon bonds include the PIMCO 25+ Year Zero Coupon U.S. Treasury Index Fund (ZROZ). The Vanguard Short-Term Bond ETF (BSV) includes publicly issued U.S. government investment-grade corporate and international bonds with short-to-intermediate maturity (one to five years). The Vanguard Intermediate Term Corporate Bond Index Fund (VCIT) invests in U.S. dollar–denominated, investment-grade, fixed-rate, taxable securities issued by industrial, utility, and financial companies, with maturities between five and ten years. The top holdings in VCIT include S&P 500 Index (VOO) listed companies like Apple 2.4% (AAPL) and Verizon Communications 5.15% (VZ).
What is income risk?
The receipt of a steady stream of income from a bond portfolio is an important consideration for many investors who depend on the income distributed by the portfolio. For example, retirees will look to their portfolios for a stable and preferably growing income stream. “Income risk” refers to the variability in this income stream, and it’s very relevant to investors if they depend on cash flows from the portfolio. Since long-term bonds offer investors a longer and more certain income stream, the longer the maturity of the portfolio and the benchmark, the lower the income risk.
To find out about some other important risks and protect yourself from potential losses, please read on to Part 2 of this series.