Living Dangerously in the World of Fixed Income
Jane M. Young CFP, EA
It is important for us to stay diversified and keep a prudent amount of our portfolio in fixed income investments – but where? We can avoid interest rate risk and default risk with CDs; however, we may sacrifice on return. Currently most short term CDs are paying less than one percent. We can get a slightly better return for a longer term CD but does this make sense in such a low interest rate environment? With CDs, the biggest downfall is the lost opportunity for a higher return.
If you want a higher return and you are willing to take some additional risk, consider short term bond funds. A short term bond fund that invests primarily in treasuries and government agency bonds has a very low default risk. However, there is some interest rate risk. Interest rate risk is due to the cause and effect relationship between bonds and interest rates. When interest rates rise, after the purchase of a bond or a bond fund, the value of the bond will decrease. For example, you purchase a $20,000, 10 year bond that pays 3% interest. A few years later interest rates go up to 5% and you decide to sell your bond that only pays you 3%. When you try to sell your bond you can’t get $20,000 for it because it pays 2% less than the market rate. However, several buyers may be willing to buy your bond for a discounted value to make up for the lower than market interest rate. If you hold your bond until maturity it should sell for the full purchase value of $20,000. The inverse is also true, if interest rates go down your bond will be worth more than what you paid. The degree to which this occurs is magnified by the term or duration of the bond. Short term bonds have less interest rate risk than do long term bonds.
Default risk is the risk that the company or entity issuing the bond will be unable to pay you back. In essence a bond is a loan made to a company or a government entity for a specified interest rate over an agreed upon period of time. US Government bonds and bonds backed by the US Government have an extremely low risk of default. Corporations, Municipalities, and other governmental entities have varying degrees of risk depending on their financial stability. Most bond issuers are assigned a rating to help investors assess the potential default risk of a bond.
A mutual fund has less default risk than an individual bond because you are buying an ownership share in several different bonds. However, you have less control over interest rate risk. If you own an individual bond you can hold it until maturity. If you own a mutual fund, the fund manager may be forced to sell bonds at an inopportune time due to a high rate of withdrawals. If the fund manager could hold all of the bonds to maturity there would not be an actual drop in value. However, bond funds must reflect a share price based on the current value of the bonds held in the portfolio.
If you want a higher return you may want to consider intermediate term bonds but be prepared for a corresponding increase in the level of interest rate risk. If you want to maximize return you could consider high yield or junk bonds. However, be very careful in this arena because high yield bonds are subject to both interest rate risk and default risk. In the current environment, interest rate risk and default risk are very high. Unless you are an expert in high yield bonds, this is a lot of risk to take on the portion of your portfolio that is designed to be less risky and serve as a buffer against the stock market.
Most of my clients are best served by investing in a combination of CDs, high quality short term bonds, and some high quality intermediate term bond funds. Unfortunately, there are few really good options in the current fixed income market.