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Risk and Bond Returns

BOND INVESTORS FACE a number of risks, such as inflation eroding the spending power of their interest payments and the possibility that the issuer of their bonds might default. But with interest rates relatively low, the big concern today is that rates will rise sharply. That would drive down the price of existing bonds, which will appear less attractive compared to newer bonds with their higher interest payments.

For an individual bond or bond fund, this risk is captured by a measure known as duration. For instance, if a bond has a duration of seven years, its price will likely climb 7% if interest rates fall by one percentage point and lose 7% if rates rise by a full point. If interest rates climb by one percentage point, bond investors today could easily lose more to price losses than they’ll collect in interest over the course of a year.

On their websites, many mutual fund companies report the average duration of the bonds in their funds. You can also find duration information for funds at Morningstar.com. Looking at big potential losses on your intermediate or long-term bonds? If you swap into short-term bonds or cash investments, you will reduce the chance of a large loss, but you will pay a price in the form of reduced income.

What if you stay put and interest rates do indeed increase? You might focus on the silver lining: Rising rates will ultimately help your bond portfolio, as you invest new savings—and reinvest interest payments and the proceeds from maturing bonds—at the higher yields. One rule of thumb: If you’re reinvesting your interest payments, you will benefit over the long haul if interest rates rise, provided your investment time horizon is longer than the duration of your bonds or bond funds.

In that scenario—where your time horizon is longer than your bonds’ duration—falling interest rates will, by contrast, work against you. Yes, the price of your bonds will get a short-term boost from an interest-rate decline. But your long-run return will be hurt because you will be reinvesting interest payments at the lower yield.

What if you would rather not see your bond portfolio roughed up by rising rates? Instead of a portfolio with, say, 60% stocks and 40% bonds, you might opt for 75% stocks and 25% cash investments—or, alternatively, close-to-cash investments, in the guise of short-term bonds and certificates of deposit. The expected long-run return of those two portfolios should be similar. Indeed, historically, shorter-term bonds have delivered much of the yield of longer-term bonds, but with significantly less risk.

Next: Costs and Bond Returns

Previous: Asset No. 2: Bonds

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