Making Financial Sense: Bonds

James C. Knapp, AIF®

The latest data from the Society of Actuaries show that for men who live to age 65, average mortality is 86.6 years and for women it’s 88.8 years. As you know, your life isn’t average. I suggest thinking more broadly about longevity.

Of women with average health, 31 % will live to 90 and 12 % will live to 95, according to the Social Security Administration’s mortality data. Among women in better-than-average health, 42 % will live to 90 and 21 % will live to 95. I implore you to please be as involved as possible with the decision making process regarding your financial independence. Don’t rely solely on your significant other.

Women tend to have a higher proportion of their assets in low-volatility investments like cash or bonds, according to TIAA’s report Retirement Gender Gap (October 2016). This can create potential challenges as you try to make your money last a lifetime.

It’s Back-to-School season and staying on the topic of bonds, please walk with me as we head to class together. Like many courses, the knowledge may benefit you for many years to come. Welcome back to school…..Bond School.

This isn’t meant to be an all encompassing tutorial; though I’ll cover duration, standard deviation and the Sortino ratio.

Are bonds safe? …. Let’s come back to that and you can answer it for yourself.

One key metric I suggest monitoring is your bond portfolio’s Duration. Duration is the measure of the sensitivity of a bond’s price (the value of its principal) to a change in interest rates. If you own a bond, you are exposed (positively or negatively) to changes in interest rates.

Two things about duration: (1) Longer term bonds have more duration  and (2) Lower coupon bonds have more duration. There is a rule of thumb in bond mathematics: If interest rates go up by one percent, the price of the bond will decline approximately (duration) percent. It’s a rule of thumb; it is not a perfectly exact calculation.

As an example, if your duration of a 10-year note is 9 and interest rates rise from 1.6% to 2.6%, the bond will lose approximately 9% of its value. SO RATES GO UP BY 1% and THE BOND GOES DOWN 9%??? (This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.)

So I ask you again, are bonds risky? You mean bonds lose value?

With rates hovering near all time lows, some investors have lengthened their duration in order to get a little extra yield. By moving into longer-dated bonds, these investors have massively increased their interest rate risk. Investors buying long-term 30-year government bond funds with a duration slightly over 21 may not be aware that if rates increase one percent that the value of that bond will DECLINE 21% if sold prior to maturity!!! Think about what happens if interest rates rise two percent, which history has shown can and often does happen. My conjecture is that investors are not aware that their government bond funds could decline 35-40%. (This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.)

Corporate bonds have duration, too. Though the math is a little more complicated to account for credit risk investors take, a corporate bond is also sensitive to interest rate changes. This can surely be seen during what was commonly known as the Taper Tantrum of 2013. Interest rates rose from 1.6% to 3% quickly. A well-known computer and cell phone maker issued 10-year bonds, one of the largest bond issues in history, and shortly after you bought this bond at 100, it fell to 90. I bet those investors who sold prior to maturity did not plan on losing 10% in this bond.

Keeping a mindful eye on the duration of your portfolio is important. Interest rates have been going down for so many years, investors may have forgotten that they can rise too. As the examples have shown, interest rate movements can cause losses.

I suggest that you find out what your portfolio’s duration is to better understand how your portfolio may react in various market environments.

You may be familiar with Standard Deviation--a measure that is used to quantify the amount of variation from its investment return average. A low standard deviation indicates that the investment returns tend to be close to the return average, while a high standard deviation indicates that the returns are spread out (bigger gains and bigger loses).

I believe focusing on downside risk management is the key to managing solid investment returns and preserving capital. The Sortino Ratio may be a better gauge than the Standard Deviation. The Sortino Ratio differentiates harmful volatility from total overall volatility by using the asset's standard deviation of negative asset returns, called downside deviation. The Sortino Ratio is a useful way to evaluate an investment's return for a given level of bad risk. Since this ratio uses the downside deviation as its risk measure, it addresses the problem of using total risk, or standard deviation, as upside volatility is beneficial to investors. A higher Sortino Ratio helps manage risks.  

This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing. For example, assume mutual fund X has an annualized return of 12% and a downside deviation of 10%. Mutual fund Z has an annualized return of 10% and a downside deviation of 7%. The risk-free rate is 2.5%. The Sortino ratios for both funds would be calculated as:

Mutual Fund X Sortino = (12% - 2.5%) / 10% = 0.95

Mutual Fund Z Sortino = (10% - 2.5%) /   7% = 1.07

Even though Mutual Fund X is returning 2% more on an annualized basis, it is not earning that return as efficiently as Mutual Fund Z, given their downside deviations. Based on this metric, Mutual Fund Z is an appropriate investment choice.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.  Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield.

Zero coupon bonds are subject to large price fluctuations if sold prior to maturity. Investors pay ordinary income tax every year even when no payments have been received. The government guarantee applies only to the timely payment of principal and interest, not to market value if sold prior to maturity.

An increase in interest rates may cause the price of bonds and bond mutual funds to decline.

Investing in mutual funds involves risk, including possible loss of principal.

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Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.