What is the risk of investing in bonds?  This is a relevant question considering that investors have allocated a substantial amount of cash to bonds over the last several years.  Investors’ move toward bonds was motivated by big drops and volatility in the stock market, bonds produced strong returns caused by the demand for bonds, and the Federal Reserve’s policy of lowering interest rates to historically low levels.

For the purposes of this article we are going to focus on bond fund risk.  Most investors own bonds through mutual funds rather than individual bonds, and the two have different risk characteristics.    Below are the risks associated with bond funds:

1.  Liquidity Risk – How liquid is the bond fund?  The less liquid the bonds that comprise the bond fund the higher the bid/ask spread.  The higher the bid/ask spread the more a bond fund will pay for a bond purchase within the fund.  These costs should lower the returns.

2.  Credit Risk – Credit risk also known as default risk is based on the bonds of various companies/agencies/government, etc. that the fund owns.  In other words, one could calculate the credit risk based on the collection of bonds the fund holds.  Most bonds have credit risk ratings provided by one of the major ratings agencies (e.g., Standard & Poor’s, Moody’s).  These agencies are paid by bond issuers, not investors.

3.  Currency Risk – Currency risk could be an issue for foreign owned bond funds.  Currency risk could be reduced if hedged properly.  If un-hedged, typically when the U.S. dollar increases in value relative to foreign currencies the bond fund return will be reduced.  However, if the U.S. dollar decreases the opposite is true [the bond fund return will increase].

4.  Interest Rate Risk – This is the risk of rising interest rates and bond fund values.  Interest rates and bond fund values have an inverse relationship.  Therefore, if interest rates increase the value of the bond funds will decrease.  One measure of a bond’s interest rate risk is its’ final maturity, i.e., the date when investors are to have their principal repaid.  However, a better measure of a bond fund’s interest rate risk would be its duration.  Duration takes into account the timing of all expected cash flows from the bonds in a portfolio, and can be interpreted as the percent change in price of the fund per a 1% change in overall interest rates.  The higher a bond fund’s duration the more interest rate risk exposure it has.  Below are three examples of bond fund duration and risk:

A.  Vanguard Short-Term Bond Index Fund Duration = 2.7 years

B.  Vanguard Intermediate-Term Bond Index Fund Duration = 6.5 years

C.  Vanguard Long-Term Bond Index Fund Duration = 14.7 years

The longer the average maturity of a bond fund the higher the duration will be for the bond fund.  For example, if interest rates [the 10 year Treasury note would be a good proxy] rose by 1% the Vanguard Intermediate-Term Bond Index Fund Value would drop approximately 6.5%.  Considering interest rates are the lowest they have been in 60 years, interest rate risk should be on every bond fund investor’s radar.  We have been in a 30 year bond bull market mainly because interest rates have dropped to almost zero [Federal Reserve discount rate].  Therefore, the most likely long-term direction for interest rates is upward.  The Federal Reserve has stated that it will allow interest rates to rise as soon as unemployment returns to a more normal level, or if price inflation starts to increase at an unfavorable rate.

5.  Sector Risk – There are many sectors in the bond asset class.  Treasury, corporate, asset backed, municipal and high yield just to name a few.  The question to ask is whether the bond sector being analyzed is overvalued or undervalued?  For example, in our opinion, the U.S. Treasury sector is overvalued relative to other bond sectors.  The yield to maturity -YTM [one measure of the future return of a bond/fund] for the Vanguard Intermediate-Term Treasury Fund is currently .90%, and the YTM for the Vanguard Intermediate-Term Investment Grade Fund is 2.1%.  These two funds have approximately the same duration, but the Vanguard Intermediate-Term Investment Grade Fund’s YTM is 1.2% higher.  The Vanguard Intermediate-Term Investment Grade Fund does have some credit risk and the Vanguard Intermediate-Term Treasury Fund has no credit risk [it is backed by the full faith of the U.S. Gov’t].  However, it appears based on the YTM the Treasury sector is over-valued.

Given the bond investing risks above, should you invest in bonds?  We believe the exposure to bonds in one’s portfolio is a function of the goal, time horizon, risk tolerance and financial profile of each individual investor.  In addition, the risks discussed above will be part of the equation regarding bond exposure.  For most investors, bonds will be used to diversify the portfolio.  In addition, there are many other factors that may influence bond prices/bond fund values.  Below are just a few:

A.  Sovereign Debt Values

B.  Federal Reserve Policies

C.  Global Macro Events

D.  Global GDP Growth

E.  Inflation

In conclusion, there is plenty of risk in the bond market.  The bond exposure that an investor chooses depends upon a careful analysis using the risks that we mentioned above.  Ultimately, the amount of bond exposure in one’s portfolio should be evaluated periodically based on several variables.

Kirk Weiss & Tom Franks