Bonds (or fixed income instruments) as well as bond funds (also known as collective investment schemes or mutual funds) are rightly-so classified and categorised to be at the lower end of the risk spectrum of asset classes within global capital markets. Their distinct defensive characteristics have shown time and time again that this asset class remains robust during times of heightened volatility as the consistent income feature makes the asset class appealing to investors. One of the key risks investors relate to with a bond investment is the credit risk (financial strength) of the bond issuer, however there are a number of inherent risks within a bond (or bond fund) which must not be overseen, and that is primarily interest rate risk.
The proper jargon for interest rate risk is duration risk and is defined as a measure of the sensitivity of a bond’s price movements (each bond has its own distinct features such as coupon, underlying yield and maturity date) to a given change in interest rate. In simpler terms, investors ought to know what price change to expect on a fixed income instrument with say for example and upward or downward shift in interest rates by 1.0 per cent. The unit of measurement of duration is in years and is practically the time required for a bond to re-pay itself. If a bond has a duration of 4.5 years, this means that if interest rates had to go up (or down) by 1.0 per cent, the price of that bond is expected to go down (or up) by about 6 per cent, hence the inverse relationship between interest rates and prices.
The longer the bond and the lower the coupon, the higher the duration and hence the large the interest rate risk. In practice, for example, long-dated Investment Grade sovereign bonds bearing small coupons would have a larger inherent interest rate risk than say than a short dated High Yield bond with a higher coupon. Naturally, in terms of credit risk, these two types of bonds are miles apart and high yield bonds are riskier than investment grade bonds.
Particularly at times when interest rates are flirting with historical lows and bond spreads continue to grind tighter, the concept of capturing a bond or a bond portfolio’s credit risk becomes imperative, especially when the downside potential for yields to go lower is limited and the risk of interest rates to go higher is larger. Investors needs to weigh the pros and cons of their bond investments (both directly through individual bonds and via bond funds) and need not needlessly expose themselves to excessive interest rate risk.
With interest rates being so low in today’s environment, bond prices have shifted higher in the process. Just as much as bond prices go up, they can likewise come down, just like any other asset class, despite their defensive characteristics. In a rising interest rate scenario, investors would want to benefit from higher rates and the growth of the economy, thereby either shifting into equities or say by selling their bond holdings only to get back into the market a more attractive yields, and subsequently cheaper bond prices. The concept is simple: the higher the bond duration (interest rate risk), the more volatile the price of the bond.
There are those investors who are simply interested in locking in a yield today and are not particularly concerned with bond price volatility (as long as the bond pays up in full at maturity), better known as buyers-to-hold. These investors are they type who are willing to extend their duration profiles (and hence expose themselves to greater interest rate risk) by going for longer dated bond simply because they have no intention of selling their bonds throughout the lifetime of the bond. And this is where the concept of opportunity cost kicks-in in portfolio and duration management. It all boils down to interest rate expectations and the likelihood of imminent changes in interest rates. Say an investor purchases a bond with a modified duration of 5, in the event that interest rates increase by 1.00%, the price of the bond would decrease by 5 per cent.
Bond portfolios should never be skewed in one particular way or another and should be balanced between longer bonds (highly sensitive to interest rate fluctuations) with positions that are less interest rate sensitive, such as high yield bonds (which nonetheless have a higher credit risk assigned to them on the other hand). In doing so, in a rising interest scenario, investors would have the necessary firepower (liquidity) to take advantage of higher rates. If on the other hand interest rates remain anchored at lower levels, the longer-dated bonds will be expected to provide steady income and positive capital gains.
Mark Vella is an Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.
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