Managing Bond Risks - Interest Rate Risk & More
All investments are subject to risk, although
the types of risk can vary. While you can't totally eliminate
these risks, you can develop strategies to reduce them. For bonds,
consider these strategies:
- Interest rate risk - Interest rates and bond prices move in opposite
directions. A bond's price will rise when interest rates fall
and decrease when interest rates rise. This occurs because the
existing bond's price must change to provide the same return as
an equivalent, newly issued bond paying prevailing interest rates.
The longer the bond's maturity, the greater the impact of interest
rate changes. Also, the effects of interest rate changes tend
to be less significant for bonds with higher-coupon interest rates.
To reduce this risk, consider holding the
bond to maturity. This eliminates the impact of interest rate
changes, since the total principal value will be paid at maturity.
Thus, selecting a maturity date that coincides with your cash
needs will help reduce interest rate risk. However, you may still
receive an interest income stream that is lower than current rates.
Selecting shorter maturities or using a bond ladder can also help
with this risk.
- Reinvestment risk - You
typically know what interest income you'll receive from a bond,
but you must then take the periodic income and reinvest it, usually
at varying interest rates. Your principal may also mature at a
time when interest rates are low.
Staggering maturities over a period of time
(laddering) can lessen reinvestment risk. Since the bonds in your
ladder mature every year or so, you reinvest the principal over
a period of time instead of in one lump sum. You may also want
to consider zero-coupon bonds, which sell at a deep discount from
par value. The bond's interest rate is locked in at purchase,
but no interest is paid until maturity. Thus, you don't have to
deal with reinvestment risk for interest payments, since you don't
receive the interest until maturity.
- Inflation risk - Since
bonds typically pay a fixed amount of interest and principal,
the purchasing power of those payments decreases due to inflation,
which is a major risk for intermediate- and long-term bonds.
Investing in short-term bonds reduces inflation's
impact, since you are frequently reinvesting at prevailing interest
rates. You can also consider inflation-indexed securities issued
by the U.S. government, which pay a real rate of return above
inflation.
- Default and credit risk - Default risk is the risk the issuer will not
be able to pay the interest and/or principal. Credit risk is the
risk the issuer's credit rating will be downgraded, which would
probably decrease the bond's value.
To minimize this risk, consider purchasing
U.S. government bonds or bonds with investment-grade ratings.
Continue to monitor the credit ratings of any bonds purchased.
- Call risk - Call provisions allow bond issuers to replace
high-coupon bonds with lower-coupon bonds when interest rates
decrease. Since call provisions are generally only exercised when
interest rates decrease, you are forced to reinvest principal
at lower interest rates.
U.S. government securities do not have call
provisions, while most corporate and municipal bonds do. Review
the call provisions before purchase to select those most favorable
to you.
Keep in mind that the assumption of risk
is generally rewarded with higher return potential. One of the
safest bond strategies is to only purchase three-month Treasury
bills, but this typically results in the lowest return. To increase
your return, decide which risks you are comfortable assuming and
then implement a corresponding bond strategy.
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