Unseen Risks Lurking In The Bond Market
Over the last thirty years bonds have become a staple for investors looking to reduce risk in their portfolios. Until interest rates normalize, we recommend investors re-examine the role bonds play and consider finding other ways to reduce risk in their portfolios.
Why are we so concerned with bonds when most investors and other investment professionals see bonds as the safe, conservative part of their portfolio? Having a better understanding of the two primary components of risk and how they can adversely affect bonds, should help explain our thinking.
Interest Rate Risk
As interest rates move up, the value of a bond will likely go down in value. For example, if interest rates were to rise 2%, the value of the average 10 year investment grade corporate bond would decrease in value approximately 15%1. If you hold the bond to maturity, and the bond does not default, you would get the full value of your investment back in 10 years. However, if you need to access that capital during a time of rising rates, you would have to realize a loss. Even if you don’t need the money, the emotional impact of seeing what investors perceive to be their “safe money” go down a lot, may cause them to realize losses. Our message is that with interest rates at all time lows, there could come a time where rising rates have a significant impact on the value of bond prices.
Are Rates Poised to Increase?
10-Year Treasury Constant Maturity, 1/1/1962-1/1/2020
Higher Rates will Hurt Bond Values
Impact of 2% Rate Increase on Bonds by Maturity
(Investment Grade Bonds)
Default Rate Risk
Most bond investors are aware that if interest rates move up, the value of their bonds will likely go down. However, we are concerned that default rate risk is not commonly understood or appreciated today. Owning an investment grade bond, mutual fund or ETF doesn’t mean you are immune to risk or principal loss.
We need only look at 2008, as an example of what can happen. During this time there was a tremendous amount of rating downgrades due to a painful recession. This put a lot of pressure on the bond market as liquidity dried up, prices dropped and default rates spiked. While the government stepped in to help stabilize the situation there is not guarantee this will happen the next time the bond market experiences a significant decline.
Cumulative Historic Default Rates by Credit Rating
Source: Moody’s Investor Service Corporate Bond Defaults 1970 – 2012 Cumulative Default rates across 20 year maturities normalized
Should we get out of the water?
We are not making any predictions, however, we are aware of these risks and prepared should the price of bonds start a significant decline. An investment grade bond is only investment grade as long as the rating agencies deem it as such. Once they get downgraded their price can come under pressure, they can lose access to the capital markets, and some times simply cannot pay back the lenders.
With interest rates at all time lows and the percentage of BBB rated bonds at all time highs, there is more risk in the bond market than most investors realize.
1) Source: The American Association of Individual Investors
2) Source; Bloomberg
3) Source: Reuters
All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.