Including bonds in your portfolio is clearly important to protect against adverse economic conditions and falling equity markets, however, just as investors are very selective about the types of stocks to hold, they need to be equally selective with their bond allocations. It’s easy to think of US Treasuries as safe havens, and that’s likely true if held until maturity, however most investors don’t hold bonds until maturity and therefore must pay close attention to the risks inherent in various types of bonds.
There are two primary components to risk within bonds: credit risk and interest rate risk.
Credit risk is easy to understand. If you own bonds of a company that is struggling financially, they may not pay back their loans, and therefore holders of their bonds will see the value of those positions decline, possibly all the way to zero.
Interest rate risk is a bit more complex as it considers the present value of previously secured future cash flows relative to the present value of currently available future cash flows. In other words, given the same risk and time frame, investors will pay more for a bond offering higher cash flows. Therefore, if interest rates increase, and investors can purchase new bonds with higher interest payments, then the previously available bond with lower interest payments will suffer a price decrease. The longer the term of the bond, ie, more interest payments to collect, the more sensitive the bond’s value is to increasing interest rates.
For a recent example, consider the price movement of our nation’s 10-Year Treasury note over the last 5 weeks. On Monday, November 7th, the day before the presidential election, the $1,000 par value 10-Year note was trading for $1,093. As of Friday, December 9th, that same $1,000 par value 10-Year note closed for trading at $811, representing a 26% decline in value.
That kind of price behavior would certainly garner the attention of investors in the stock market, and the same should be true in the bond market. As investors adjust to the new reality of rising rates, they will be well served to consider the risks inherent to bond portfolios and allocate accordingly.