Traditional wisdom suggests that fixed income investments can potentially offer resilience and lower risk when economies slide into recession. At the same time, assets like stocks could expose your portfolio to greater volatility and a higher likelihood of short-term losses.
The point noted above is generally valid if you invest in major government or highly rated corporate bonds. Nevertheless, investors need to understand that the fixed income market has different layers of risk. Learning to gauge that risk and assess the various factors affecting market value and the yield of fixed income securities is essential when planning an investment strategy.
Bond prices and returns are affected by several factors, but three of the most significant are interest rates, duration, and credit.
1. Interest rates – the inverse relationship with bonds
Interest rates have what is called an “inverse relationship” with bond prices. This means that bond prices usually fall when the cost of borrowing moves higher. Why?
Let’s say Company A issues a three-year bond at $1,000 that pays a coupon of four per cent annually. If the prevailing interest rate stands at three per cent, investors can earn more from the bond. However, if the prevailing interest rate rises to five per cent, the bond's coupon becomes less attractive, and the bond's price could fall.
When the bond’s price declines, its yield (or overall return) increases because the investor pays less to receive the same interest rate.
Conversely, if there is a cut in interest rates, then the price of that bond may rise.
2. Duration – a tool for risk management
Because the interest rate impact on investments is so significant, market participants need a way to measure how sensitive their fixed income holdings are to rate changes. That metric is called duration.
Duration in fixed income assesses the different characteristics of a bond – yield, maturity date, and coupon payment – and then produces a single number expressed in years. The longer the duration, the more significant the potential change in value resulting from interest-rate movements.
So, if interest rates rise, a bond with longer duration will lose more value. But if interest rates fall, the longer-duration bond will increase more.
Duration is, therefore, an effective tool for portfolio risk management.
If investors are willing to risk more significant fluctuations in value in exchange for potentially larger long-term gains (in other words, surmise that interest rates will drop), they might consider investing in longer-duration fixed income assets.
Or, if they prefer greater stability and a smaller but steady income, then short-duration bonds might be a more prudent choice.
3. Credit – where quality counts
One of the limits of the duration metric is that it does not account for the importance of credit risk in fixed income.
When a government, company or other entity issues a bond, investors need to know how much risk they are taking – in other words, the likelihood of the coupon and principal being paid in full.
A bond from a major government or corporation is considered a low-risk investment. Ratings agencies – firms that assess creditworthiness – will award the bonds a high score (anything from BBB- or Baa3 up to AAA or Aaa). These scores are known as “Investment Grade”. In return for high-quality credit and low risk, investors are willing to pay a higher price and receive a lower investment return.
If a company is struggling with a higher risk of defaulting on its debt, it will offer higher interest rates to attract investors, and the bond price will be cheap relative to an Investment Grade issue. This higher credit risk nature will be reflected in the bond’s risk rating (BB+ or Ba1 and below).
If one of the agencies considers that the risk of default has increased, it will change the rating on a bond, which can lower its price and increase the yield.
By understanding the interaction of interest rates, duration and credit in fixed income investing, it’s possible to adjust your investment strategy to fit changing economic circumstances.
