By Nick Clay
The Financial Industry Regulatory Authority (“FINRA”) believes investor protection begins with education. Working with its member firms/broker dealers, FINRA looks to help investors build their financial knowledge and provide them with essential tools to better understand the markets and basic principles of investing and investment risk. The first step in assessing investment risk is to understand the types of risk to which a particular category of fixed income securities might expose you. You may own fixed income securities, in the form of individual bonds or bond funds. Currently, interest rates are hovering near historic lows. Many economists believe that interest rates are not likely to move lower and will eventually rise. If that is true, investments in longer dated (maturity) bonds, or bond funds that hold primarily long-term bonds may decline, perhaps significantly, when interest rates rise.
Bonds. A bond is a loan that an investor makes to a corporation, government, federal agency or other organization. The issuer of the bond enters into a legal agreement to pay you interest. The issuer also agrees to repay you the original sum loaned at the bond’s maturity date, though certain conditions, such as a bond being called, may cause repayment to be made earlier. The vast majority of bonds have a set maturity date, when the bond must be paid back at its face value, called par value.
Bond Interest Rate Risk and Credit Risk. If you hold a bond until maturity, you will get that amount back, plus the interest the bond earns, unless the issuer of the bond defaults. You also face potential market risk if you sell bonds before maturity. For example, if the price of the bonds in the secondary market is less than par and you sell the bonds, you may realize a loss on the sale. The market value of bonds may decrease if there’s a rise in interest rates between the time the bonds were issued and their maturity dates. In that case, demand for older bonds paying lower rates decreases. If you sell, you must settle for the price you can get and potentially take that loss. Market prices can also fall below par if the bonds are downgraded by an independent rating agency because of problems with the company’s finances.
Bond Call Risk. Some bonds have a provision that allows the issuer to “call” the bond and repay the face value of the bond to you before its maturity. Often there is a set “call date,” after which a bond issuer can pay off the bond. With these bonds, you might not receive the bond’s original coupon rate for the bond’s entire term. Once the call date has been reached, the stream of a callable bond’s interest payments is uncertain, and any appreciation in the market value of the bond may not rise above the call price.
Bond Reinvestment Risk. Similar to when a homeowner seeks to refinance a mortgage at a lower rate to save money when loan rates decline, a bond issuer often calls a bond after interest rates drop, allowing the issuer to sell new bonds paying lower interest rates, thus saving the issuer money. The bond’s principal is repaid early, but the investor is left unable to find a similar bond with as attractive a yield.
Bond Funds. There are four types of bond funds: Mutual funds, closed-end funds, unit investment trusts (UITs) and exchange traded funds (ETFs). While there are important distinctions between them, each type of fund allows an investor to instantly diversify risk among a pool of bonds at a low minimum investment. It is important that you understand the different fund types and how bond funds differ from individual bonds.
Bond Fund Risk. Bond funds, in all of their various forms, carry all of the risks of individual bonds as well as several other important idiosyncratic risks in a rising interest rate environment. Bond funds are comprised of a great many issues. While a number of individual issues may remain in the portfolio until they mature, there is no single date at which the entire portfolio of the fund will mature. In fact, most bond funds maintain a “constant” maturity. For example, the maturity of a long-term bond fund will always remain long term, somewhere between 15 and 25 years. The maturity of a short term bond fund, on the other hand, will always be short, that is, somewhere between one and three years. Consequently, unlike an individual bond, the NAV of a fund does not automatically return to par on a specified date. As a result, the price at which you will be able to sell shares of a bond fund cannot be known ahead of time. It will be determined by conditions prevailing in that sector of the bond market when you sell your fund. If you own an individual bond, each year its market value (its price) moves one year closer to par. But because it has a constant maturity the NAV of a bond fund follows interest rates. For that reason, its future is not predictable. Because the price of a bond fund does not return to par at a specified maturity date, it cannot quote a yield-to-maturity. As a result, any comparison between the potential return of an individual bond and a bond fund is imprecise.
Please contact your investment professional with any specific questions regarding your investments.