Many investors are scrambling to the perceived safety of fixed income in these troubled market times, but bonds have risks of their own. There is the chance that an issuer will go broke, of course, as well as the possibility that bond prices will fluctuate widely as interest rates rise and fall. And don't forget reinvestment risk–the problem investors face when their bonds mature while rates are on their way down.
One way for an advisor to work around these problems is to invest in a "laddered" portfolio containing bonds with staggered maturities. The diversification of such a portfolio helps mitigate credit risks, while the staggered maturities help avoid reinvestment shocks and offer a value-added solution whether rates go up, down, or sideways. Indeed, a bond ladder preserves flexibility while smoothing the volatility of the income stream, since at any given time the current yield of the portfolio is the average of all the bonds in the portfolio. This includes bonds purchased in periods of high or low rates.
Here's the challenge: Not all bonds and bond funds are the same. Investors and their advisors are consistently lured by high yields into high-risk bond strategies, only to lose principal. Remember the stock market crash in 1987? More money was lost in bonds that year than in stocks.
Why? As interest rates fluctuate, the present value of a bond's stream of interest payments constantly changes. And the longer the stream of interest payments, the higher the price volatility. The market value of a bond goes down when interest rates rise, because its interest rate is fixed and cannot compete with newly issued bonds paying higher rates.
In terms of variability of total return, long-term bonds look more like stocks than short-term, fixed-income vehicles. Eugene Fama studied the rates of returns of long-term bonds from 1962 to 2001, showing that these bonds historically have had wide variances in their rates of total return, without sufficiently compensating investors with higher expected returns.
The data indicate long-term U.S. treasuries have both lower average returns and higher price volatility than intermediate-term Treasuries. Investors have not been compensated for the higher risk of long-term bonds. In our opinion, the higher nominal yield of long-term bond funds is not enough to compensate the investor for their highly volatile NAVs.
Aside from the issue of volatility, bond investments also have other risks, such as a compromise between reinvestment risk (the risk that your income stream may change) and market price risk (the risk that the price of the bond may change if prevailing interest rates, inflation, or other factors cause bond prices to start fluctuating).
You Never Know
Let's say a client walks into your office one day this month with $1 million and wants to invest in a five-year bond. He tells you he wants to know what the value of that investment will be on a specific date five years in the future. My question to him would be, "Why do you need $1 million that day?" You say that date could turn out to be a terrible time to reinvest $1 million. Or it could be a great day to reinvest. You never know: Rates could be at 10%; but they also could be 2%.
Here is an opportunity for you to explain the concept of bond laddering and why your client might be better off investing $100,000 in 10 different bonds that mature consecutively each Sept. 25 for the next 10 years, thus spreading out his reinvestment risk. Next, explain that there are other ways of eliminating the reinvestment risk, such as buying very-long-maturity, zero-coupon bonds–but there would still be market price risk.
Consider how a "normal" yield curve facilitates this situation (See chart 1, page 73).
Notice that somewhere between 8 and 12 years, available yields level off. The more market price risk you take beyond that time, the less incremental return you receive for increasing your price risk. Quite frankly, you usually don't get any noticeable incremental return for locking in your yield for a longer period of time than 12 years.
Unless your client believes we're going into a long deflationary period (be sure to ask him), why take that risk? Many investors seek to eliminate market risk by investing for a shorter term in a money market fund. What they don't think about is they are taking on a high level of reinvestment risk.
Risky Money Funds?
Most investors have never considered that they are taking any risk in a money market fund, but chart 2 (top right) provides a clear example of the reinvestment risk associated with a $100,000 investment in the average money market fund during periods of falling interest rates.
Look at the drop in earnings from 2000 and 2002. That's a vivid example of reinvestment risk. An investor is subject to this risk both when interest income is received and when invested principal matures.
