In creating a bond portfolio, an investor normally aims to obtain high income, to preserve principal and possibly to earn an attractive total return (the sum of income, reinvestment income and price change). Achieving these objectives requires careful attention to risk and taxation. The following discussion lays out the basics in each of these areas, with the caveat that I do not provide advice on tax matters. At the conclusion of this article are three specific recommendations in the corporate bond category, valid as of August 19, but subject to revision or revocation thereafter.
Types Of Risk Faced By Bond Investors
As a general rule for bonds, the higher the income (the greater the yield, in other words), the greater the risk you must take. Bond risk comes in several varieties:
Default Risk: You will not receive expected income or you will incur a permanent loss of all or–more likely–part of your principal, if the issuer fails to make a scheduled interest payment or to redeem the bond at full face value at maturity. Credit ratings by Moody’s, Standard & Poor’s and Fitch Ratings are those organizations’ estimates of probability of default and expected loss given default.
Credit-Related Price Risk: You may incur a temporary loss of market value because the issuer’s perceived default risk increases, even if the issuer eventually redeems the bond at full face value at maturity. A rating downgrade signals that the credit rating firm believes the issuer’s default risk has increased.
Interest Rate Risk: You may suffer a loss of market value, even if payment of future coupons and principal remain highly assured, due to a rise in the general level of interest rates. In general, this price risk is greater the longer the bond’s maturity and the lower its coupon. Early redemption features (see Prepayment Risk, below) also affect the equation.
Illiquidity Risk: You may not find a ready market for a bond that you wish to sell, either for strategic reasons or to raise cash to meet an expense. In general, there is a deeper market for bonds of issuers with large amounts of public debt outstanding than for those with small amounts outstanding. U.S. Treasury bonds are considered the most liquid, while liquidity varies widely among corporate issues.
Prepayment Risk: Some corporate bonds’ terms permit the issuer to redeem (“call”) the security prior to its scheduled maturity. That is rarely the case for Treasurys. If your bond is retired in this way, the reinvestment options available to you on bonds of comparable quality may be at significantly lower yields than that at which you bought the called bond. You may find yourself in a similar position if a drop in interest rates causes homeowners to refinance their mortgages, resulting in early repayment of principal on mortgage-backed securities (MBS).
Loss of Purchasing Power: Income derived from a bond with a fixed-rate coupon purchases fewer goods and services as time goes on, due to inflation.
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Approaches To Limiting Risk
You can limit your default risk by establishing a minimum rating on bonds you select for your portfolio. Ratings are subject to change, so maintaining a quality level consistent with your risk tolerance requires monitoring your holdings and making any changes necessitated by rating downgrades. Limiting credit-related price risk requires forward-looking, fundamental analysis of the issuer’s financial condition. Published bond research can be a useful supplement to your own efforts in this area. Bond research can also provide helpful input on valuation.
To limit interest rate risk, you can establish a maximum maturity (in years) or target an average maturity for the portfolio. (A more precise way of measuring interest rate risk, provided you have access to the data, is duration, which takes into account coupon rate and yield, as well as maturity.) As with ratings, your maturity mix requires monitoring. A bond’s remaining maturity shortens over time, meaning that it may eventually become a more conservative (and lower-yielding) holding than you consider optimal.
Another way of limiting interest rate risk is to include in your portfolio bonds with floating rate coupons. That feature provides some protection by increasing the income generated by a bond in conjunction with rises in a specified benchmark interest rate.
The most practical way to limit illiquidity riskis to stick to bonds of big, well-known issuers with large amounts of public debt outstanding. To limit prepayment risk on corporate bonds, emphasize noncallable issues or bonds that have long periods remaining until they become callable and are trading below their initial call prices. For mortgage-backed securities, lower-coupon issues are generally less vulnerable to prepayment than higher-coupon issues. Note, however, that all else being equal a low-coupon MBS issue will likely have greater price volatility in response to a change in interest rates than a high-coupon issue.
As for the risk of loss of purchasing power, unless you foresee deflation, which has the opposite effect of increasing the purchasing power of a fixed amount of income, it is worthwhile considering allocating part of your portfolio to Treasury Inflation-Protected Securities (TIPS). As a further point, rising inflation tends to push interest rates higher. Keeping a portion of your portfolio in shorter-maturity bonds enables you to reinvest proceeds of maturing bonds at higher rates, thereby lessening the adverse impact of lost purchasing power.
Along with these various techniques, diversification is essential for limiting risk in a bond portfolio. It begins at the asset category level. The table below details performance over a 36-year period of four different bond types, arrayed left to right from lowest to highest credit risk. Also shown is a portfolio with a 25% market value weighting in each category. Equally weighting the four categories does not necessarily represent the optimal mix. The point of this illustration, however, is that the portfolio that incorporates all four bond types achieves a meaningfully higher risk-adjusted return (measured by the Sharpe ratio) than any single category delivers.
Diversification at the issue level means spreading your exposure over many different issuers. This is prudent because not all price-injuring impairments to credit quality are foreseeable. Some institutional investors follow a rule of concentrating no more than 2.5% of their portfolio in any single bond. Following that rule requires owning at least 40 different issues. No specific number of holdings is appropriate for every investor, however. For instance, if achieving a superior total return ranks high among your investment objectives, be aware that wide diversification can make it more difficult to outperform an index fund.
To the extent that you do diversify by holding a large number of corporate issues, make sure to spread your risk among industries. Holding bonds of many different oil and gas producers, for example, does not represent true diversification. All those companies’ issues will tend to move together with fluctuations in energy prices.
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Tax Considerations
Caveat: I do not offer tax advice. Consult your tax advisor prior to investing in bonds.
Different varieties of bonds are treated differently for tax purposes.
Municipal bonds (excluding certain taxable varieties) are exempt from federal taxes. In addition, an investor in tax-exempt “munis” who is a resident of City X in State Y is exempt from those entities’ taxes on bonds issued by them. (This characteristic is commonly termed “triple tax free.”) Note, however, that income from some municipal bonds–for example, those that fund stadiums, airports or other business-type enterprises–may be subject to alternative minimum tax.
U.S. Treasury bonds are subject to federal taxes but exempt from state and local taxes. Bonds of federal agencies are subject to federal taxes; some agencies’ bonds are exempt from state and local taxes, while others are not. Corporate bonds are subject to federal, state, and local taxes.
Investors who own both taxable and tax-deferred accounts (such as IRAs or 401ks) can optimize their tax positions by locating bonds where it makes most sense from a tax standpoint. For example, fully taxable corporate bonds are generally best suited for tax-deferred accounts.
Interest on taxable bonds is taxable at ordinary income rates. Capital gains and losses are subject to the applicable rules concerning holding periods and tax rates. Special rules apply to bonds initially offered at material discounts to face value.
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