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The bond section of an investors’ global portfolio is typically considered to be the safest asset class, which is why investment advisors typically include them in order to preserve the wealth of their clients. Bonds are popular because they are much less risky than stocks, and the returns are more predictable, since bondholders receive coupon payments (interim interest payments) and a final lump sum at a predetermined point in time. Bond investors find it easier to conceptualise their return than with a portfolio of stocks.
Despite bonds being less risky and more predictable, this does not necessarily make them “simple” investments, as the risk elements an investor is exposed to can vary considerably. The two key aspects of a bond are credit risk – the likelihood that it will be repaid – and duration risk – how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows.
Just like stocks, there is a risk/return trade-off in bond investing. Bonds with longer duration or lower credit have higher yields and higher expected returns. In order to entice investors to tie up their money for longer periods of time or to lend to less credit-worthy companies, borrowers must offer investors higher expected returns.
Credit risk and duration risk are two very distinct types of risks which tend to offset each other depending on the stage of the economic cycle. Companies typically default on loans when inflation and economic growth are low or declining. Interest rates decline during these periods, and long-duration bonds benefit. Conversely, when inflation and economic growth are rising, companies are much less likely to default, but interest rates tend to rise and this will hurt long-term bonds (in a marked-to-market portfolio).
Focusing on credit risk, high yield bonds and long term government bonds behave very differently in practice. High yield bonds are typically exposed to more “equity-like” risks, and are dominated by credit risk factors. On the other hand, government bonds are typically more credit worthy, making them dominated by duration factors. As intimated above, they subsequently tend to move in different directions, intuitively suggesting that combining the two into one portfolio can diversify these risks and boost risk-adjusted returns.
Dissecting credit risk further, a bond investor is faced with a plethora of different elements that affect the riskiness of a bond. To keep things simple, many international companies engage credit rating agencies that rank the riskiness of an issuer’s bond, in order for bond investors to avoid sifting through the various factors that affect the credit worthiness of an issuing company (an issue I will tackle in a separate future article).
Duration risk is more binary, however understanding how different elements, such as a call option ladder, affects the duration risk of a bond is equally important prior to investing. The introduction of features which could suddenly shorten the duration of a bond, reduces duration risk however introduces a new type of risk, re-investment risk. This is relevant to bond investors in a declining interest rate scenario whereby a bond in issue is replaced by a bond with a lower coupon, thus lowering returns.
At the end of the day, all bonds are not created equal and it is important to read the fine print in a prospectus or admission document (or at least get your investment advisor to highlight the salient points!). Make sure you know what you are buying, that you clearly understand your exposure to duration and credit risk, and are creating a balanced bond portfolio. This will keep bond risk down and returns up.
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