Investors Should Understand the Hidden Risks in Bonds

“The best-laid plans of mice and men, go oft awry.” —Robert Burns, 1785

Most people appreciate the need to regularly save money for college expenses, retirement and other occasions.

A little savings over a long period of time adds up to a lot of money thanks to the magic of compounding interest.

And most of us understand that saving alone is only part of the process.

A well thought out financial plan should be developed, and reviewed and updated regularly since change is the rule, not the exception, as we get older and our children grow up.

But most people do not realize that these two important ingredients of our financial well-being, saving money and following a well thought out financial plan, can be ruined simply by failing to include a crucial third ingredient — managing risk.

One of the few unpleasant things I have to do in helping clients invest and plan for the future is to try to repair or rebuild an investment portfolio that has been destroyed by a previous financial adviser.

Many times an adviser has put excessive risk in my client’s portfolio, either because he/she didn’t understand the risk or simply wanted to earn a big commission – or both.

Mismanaging risk will almost certainly put your best-laid plans awry.

So today I’m going to describe a very real and significant risk that average investors (and frankly most financial advisers) frequently ignore — the interest rate risk in bonds.

Whether you are retired and living on a fixed income, or in your 30s and building an investment portfolio intended to get you to retirement, at some point you will certainly find yourself trying to understand the risks and rewards present in bonds.

Bonds can be appropriate at any stage of your financial plan because they offer many benefits including safety, income, and diversification.

And if you think bonds are boring because they only provide a fixed income payment over a long period of time, you are in fact overlooking the hidden risk I’m about to describe.

Most investors are aware of credit risk. That is, the risk that a business such as General Electric or a municipality like the Bentonville School District will not be able to pay the interest payments each year for 20 years, or pay back your initial $100,000 investment 20 years from now, if you invest in their bonds.

That is a very real risk that should be thoroughly addressed before investing in a bond (and a topic for another article).

Then there is inflation risk.

Twenty years from now, the fixed payment you are getting today on your bonds will buy a lot less due to the ever-rising cost of living (again, we’ll save it for another day).

But what about interest rate risk?

Interest rate risk is just what it sounds like – the value of your investment in a bond could be significantly impaired if interest rates (i.e. residential mortgage rates that homebuyers lock in when buying a house) go up.

I’m going to spare you the math behind the relationship between interest rates and bonds (feel free to e-mail a thank you).

Just understand that when home buyers are worried because interest rates are going higher, bond investors are susceptible to major losses in their bond portfolios.

Even though General Electric and the Bentonville School District are very strong financially and will almost certainly pay back every cent on their bonds over the next 20 to 30 years, if during your holding period interest rates rise and you need to sell some or all of your bonds because you need the money, you could suffer a permanent loss on your bonds.

The chart on the previous page illustrates the relationship.

Let’s look at an example. Today one could invest $100,000 in a Farmington school bond that will pay 3.625 percent ($3,625) tax-free each year until 2010, at which time the original $100,000 investment is returned.

Suppose in 2009 interest rates have increased 3 percent, and the investor needed the money and decided to sell the bonds one year before they mature.

He would suffer a loss of about $2,000. Since bond values go down when interest rates go up, his $100,000 investment would be worth less to a buyer of his bonds.

But assume that since interest rates are low today, the investor instead bought bonds with more income, and a much longer maturity.

For example, he could have invested $100,000 in a Pope County Arkansas Pollution Control bond that will pay 6.3 percent ($6,300) tax-free each year until 2020.

Instead of being down $2,000, his loss would be about $24,000 under the same scenario of higher interest rates in 2009.

So while it may be tempting to tie one’s money up for a longer period of time (ten more years in this example) to get more income, the hidden risk is that if you need access to the funds you could suffer a much larger permanent loss when you sell the bonds.

It’s important to remember two things about interest rate risk.

First, bond prices move in the opposite direction of interest rates.

Second, the longer you have your money tied up (i.e. 25 years until maturity) the greater the decline in price for a 1 percent increase in rates.

Professional money managers manage the risks in bonds several ways.

First, we manage credit risk by avoiding buying bonds issued by companies without a financial foundation that is strong and that can be reasonably expected to remain strong during our intended holding period.

Second, we minimize inflation risk by structuring a portfolio so that the total return after any expected withdrawals exceeds the expected rate of inflation.

Finally, we avoid interest rate risk by only investing in bonds when the risk of loss (due to rising interest rates) is minimal.

Investors that need the safety and income of bonds to protect their wealth and provide living expenses in their retirement years have two basic options for an adviser: Commission-based or fee-only.

Stockbrokers and insurance agents are commission-based and are licensed to sell financial products (annuities, mutual funds, etc.).

Unfortunately, the bonds with the most interest rate risk to investors are typically the ones that pay the most commission to a broker.

Fee-only advisers avoid this conflict of interest because they are not licensed to sell products and never receive commissions.

Instead they charge only an annual fee to protect and manage their clients’ investment portfolios.

Joe Chumbler, CFA, is a financial advisor with Boston Mountain Money Management, Inc., a fee-only professional investment management firm in Fayetteville. He may be reached at [email protected].