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Other Risks Facing Bond Investors
Other Risks Facing Bond Investors
Prepayment risk (call risk)
Reinvestment risk : The risk that bond investors forgot in the 1980s
The big mistake made by a Stanford MBA-CPA
The best cure for reinvestment risk
Foreign bonds -- an easy way to get increased yields and total returns?
Table of risks facing bond investors
Prepayment risk (call risk)
Most bonds come with a call provision
US Treasury bonds are not callable
If interest rates drop, the bond issuer calls the bonds back and refinances them at a lower interest rate
Most bonds have some form of call protection for the investor
Example
The bond can not be called until at least five years after issuance
When the bond is called, the issuer must buy the bonds back at a premium of perhaps 5 percent
Before you buy any bond, find out the call provisions of the bond
You may pay 20 percent above par for a high yielding bond, only to find that the bond will soon be called at only a 5 percent premium giving you a big loss
Reinvestment risk : The risk that bond investors forgot in the 1980s
Investing in short-term bonds reduces your interest rate risk
Prices of short-term bonds are quite stable compared with long-term bonds
But investing exclusively in short-term bonds exposes you to reinvestment risk
Reinvestment risk is the risk that you won't be able to reinvest your maturing bonds at high interest rates
Investing in long-term bonds locks you into a constant interest rate - which may be bad or good
The big mistake made by a Stanford MBA-CPA
A Stanford MBA who also was a CPA offered advice on how to retire early
"Put all your money into one-year certificates of deposits"
These short-term bank CDs have very little credit risk, but high reinvestment risk
The author offered this advice in the mid-1980s when one year bank CDs were yielding perhaps 8 percent
By 1992, however, one year bank CDs were yielding perhaps 4 percent
If you had followed this advice, your retirement income would have been cut in half!
The best cure for reinvestment risk
The best cure for reinvestment risk and interest rate risk is to diversify over time
Ladder your portfolio by dividing your investment money into 10 parts
Invest one-tenth of your money in one-year bonds or CDs
Invest another tenth into two-year bonds or CDs
Do this all the way up to one tenth into ten-year bonds
This way you lock in yields with the ten-year bonds, and you also have bonds maturing each year to reinvest if rates go up
Foreign bonds -- an easy way to get increased yields and total returns?
Foreign bonds often offer higher current yields than those available in the US
But remember, as a rule, what you gain in current yield you generally lose in principal
If you invest in a high-yield foreign bond, you generally will suffer a currency loss
And you can't hedge away currency risk and still earn a higher yield
Investing in foreign bonds also may subject you to foreign taxes that at a minimum will complicate your income tax calculation
Table of risks facing bond investors
|
Bond |
Current yield* |
Risk** |
||||
| Interest rate | Credit | Reinvestment | Call | Currency | ||
| US short-term Treasury | 5.5% | low | none | high | none | none |
| US long-term Treasury | 7.0 | high | none | low | none | none |
| GNMA | 7.5 | moderate | none | moderate | moderate | none |
| Short-term high grade corporate | 6.5 | low | low | high | low | none |
| Long-term high grade corporate | 8.0 | high | moderate | low | moderate | none |
| Junk corporate | 9.5 | moderate | high | moderate | moderate | none |
| Foreign government | varies | moderate | low | moderate | low | high |
| Convertible | 4.5 | moderate | moderate | moderate | low | none |
| Short-term municipal | 4.0 | low | low | high | low | none |
| Long-term municipal | 5.5 | high | low-moderate | low | moderate | none |
* Note that yields are only approximate as of September, 1996
** Estimates for degree of risk are approximations only