Understanding the Benefits and Risks of Bonds

March 29, 2020

Especially in times of significant stock market volatility, bonds have an important place in a balanced investment portfolio. The income that bonds generate coupled with their relatively low-price volatility can help mitigate overall portfolio risk.

Unlike stocks, which provide equity interest in a business, bonds are a form of debt in which the investor serves as the lender. A bond is, in fact, a contractual loan made between an investor and a borrower, which can be a corporation, government or municipality. In return for the financing, the institution will pay recurring interest payments, commonly known as a coupon.

Many people assume that bonds, generally speaking, are “safe”. In reality, different bonds have different levels of risk. Treasury bonds issued by the U.S. government have minimal risk and correspondingly low rates of return. Corporate or municipal bonds can have higher risk with potentially higher rewards. Regardless of the type of bond one chooses to invest in, the goal is for the investor to receive coupon payments and the bond’s face value at maturity, while also ensuring that the return offered justifies the level of risk incurred.

Reliable returns, but not risk-free
Generally speaking, bonds tend to have less fluctuation in value (volatility) compared to stocks and can provide a greater level of income stability. Bonds offer a relatively reliable level of expected return through coupon payments, similar to dividends from blue chip companies.

Although bonds have less risk compared to stocks, they are not, in fact, risk-free. The ability to repay the debt, including coupon payments, depends upon the lender’s ability to generate cash flow.

When selecting bonds to purchase, we weigh the different levels of risk and reward within the bond allocation. We believe this portion of the portfolio shouldn’t take unnecessary levels of risk as we want it to maintain conservative characteristics, particularly in times of broader distress and uncertainty.

Analyzing risk factors
At The Fiduciary Group, we routinely perform our own analyses in order to assess the credit quality of companies and municipalities issuing bonds to determine the potential value of their offerings. Risk assessments and return requirements evolve as the interest rate environment and issuer fundamentals change.

Here are a few of the key risk factors we evaluate when determining which bonds to invest in on behalf of our clients:

Credit risk – As a general rule, the higher the credit risk, the higher the required return. Similar to individuals having varying degrees of personal credit scores, bond issuers similarly have a wide array of risk profiles based upon their fundamentals. In order to mitigate the risk of default, we analyze issuer fundamentals (balance sheet and cash flow generation) to understand the ability and likelihood of repayment.

Interest rate risk – Interest rate risk is the risk that interest rates rise. If interest rates rise, existing bonds are worth less and decline in price (the coupon on the outstanding bond is no longer competitive with the rate offered on new issuances; a lower price for the outstanding bond results in a higher yield, closing that gap). The longer the maturity, the more sensitive the bond’s price will be to movements in interest rates. It is important for a bond investor to assess whether they are being adequately compensated for the additional interest rate risk of investing in longer maturity versus shorter maturity bonds. Interest rate risk fluctuates over time based on economic conditions and inflation expectations.

Long-term stability
Regardless of how bond interest rates fluctuate, our goals remain consistent. At The Fiduciary Group, we work hard to balance credit risk and interest rate risk with expected return. In all cases, credit risk is prioritized in an attempt to mitigate risk of default. For each increase in credit risk and interest rate risk, we must believe that incurring that incremental risk is justified (higher yield).

If you want to learn more about bonds and strategic ways to balance your investment portfolio, please reach out to us to get started.

AUTHOR:

SCOTT McGHIE, CFA, CPA