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Other risks facing bond investors

By David Luhman on Sat, 05/09/2009 - 23:34

Other risks facing bond investors

Bonds - call risk

In addition to interest rate risk and credit risk, bond investors face plenty of other risks. One is call risk.

Call risk is the risk that the issuer will call back the high yielding bond that you hold and refinance the bond at a lower rate. This is the same risk that a mortgage holder faces when you try to refinance your mortgage at a lower rate.

There are a couple of ways to view this risk. First, if you buy a high-yielding bond at a 20 percent premium, and then the bond issuer calls the bond back at only a 5 percent premium, you've lost a lot of money.

The other way to view call risk is in terms of lost opportunities. If you have a high-yield, long-term bond, you're probably counting on enjoying the high interest payments for the life of the bond. But if the issuer calls the bond back, you've lost the ability to lock in those high interest rates for a long time.

The best way to defend against this is to find out the call provisions of any bond before you buy it. Always find out the yield to call and yield to maturity before buying a bond.

Because call risk offers a no-win situation to bondholders, investors demand higher interest payments than they would otherwise expect. This is why Ginnie Mae mortgage securities offer a higher yield than comparable US Treasury securities.

Ginnie Mae mortgage securities and US Treasury bonds both are backed by the full faith and credit of the US government, but Ginnie Maes can be called or refinanced, while US Treasury bonds cannot be called.

Reinvestment risk

Much of the risk associated with call risk is the loss of the ability to lock in a high interest rate. This is related to reinvestment risk which is another risk facing bondholders.

When you invest in bonds, you normally can have maintenance of principal or maintenance of income, but not both. This emphasizes the difference between investing in long-term or short-term bonds.

Short-term bonds maintain principal, not income

If you invest in short-term bonds, you limit your exposure to interest rate risk. The interest rate risk you're assuming is directly related to the duration of the bond.

Suppose you're invested in a short-term bond fund whose duration is two years. If interest rates go up by 1 percent, your fund's value will drop by about 2 percent.

But if you're invested in a mutual fund whose duration is 10 years, your fund's value will drop by about 10 percent if interest rates go up by 1 percent, so in this respect the long-term bond fund is riskier.

Long-term bonds offer higher yields and steady income

Since the long-term bond fund has more interest rate risk, you might be wondering why you should even consider investing in a long-term bond fund. There are two reasons for this.

The first is that the long-term bond fund normally will have a higher yield. The second is that the long-term fund provides income stability to you by locking in interest payments for a longer time.

Long-term bonds have a down side in that they may lock you into a low interest rate if other rates go up. But long-term bonds have an advantage because they lock you into high interest payments in case interest rates go down.

Reinvestment risk defined

The risk of interest rates going down is called reinvestment risk. Here's a great example of the danger associated with reinvestment risk.

I recently listened to an audio tape which advised people on how to retire in their early 40s. The tape was produced in the mid-1980s.

To retire at the early age of 40 the author recommended you sell your large, expensive house and retire to the countryside where you can live cheaply.

The author, who was a CPA at a prestigious accounting firm and who had an MBA from Stanford, was no amateur when it came to money. But he made a mistake in his financial planning. He forgot about reinvestment risk.

How to not retire at 40

Let's walk through what the author recommended. I'm estimating some numbers here, but they're probably good estimates.

Assume the author sold a big house in Boston, and bought a small, inexpensive home in North Carolina. After swapping houses, let's say he had $400,000 in cash left over. So far so good. $400,00 is a lotta loot to retire on.

Next the author placed all his money in insured, one-year certificates of deposit. He even divided his money into twelve parts and invested each twelfth over the course of a year. This technique of dividing your money up and investing over time is called laddering and is useful in reducing your interest rate risk.

So this trained, intelligent accountant seemed to have it all figured out, right? He had little or no credit risk because of the insured nature of bank CDs, and he even broke his retirement stash up into twelfths to further cut his risk. So what's wrong with this?

Need to use maturity matching

He forgot to use what I call maturity matching. Maturity matching says that money used for short-term goals should be invested in short-term instruments. Money used for long-term goals should be placed into long-term instruments.

By retiring at age 40, the author had about 40 years of retirement to fund. This is obviously a long-term proposition. He made a mistake by putting all of his money into short, one year CDs.

Here's what went wrong. In the mid-1980s, short-term CDs were yielding maybe 8 percent. Thus his $400,000 in savings would have given him an annual income of $32,000. He and his wife obviously could live on $32,000 a year.

But by 1993, interest rates had fallen dramatically to the point where one-year CDs were yielding maybe 4 percent. If his principal had remained constant, his $400,000 would yield only $16,000 in income in 1993. It probably would have been difficult for him and his wife to live comfortably on half of their previous income.

Ladder bonds over 10 years

So instead of laddering his money over 12 months, the retiring CPA should have laddered his money over 10 years. He could have put one tenth of his money into 10-year US Treasury bonds, another tenth into nine-year Treasuries, and so on.

In this way he would have limited his exposure to both upward and downward moves in interest rates, while still keeping his money in very creditworthy Treasury bonds.

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