As Treasury bond yields remain in a low range, investors have pushed into high-yield fixed-income options to bolster income. However, people should understand the risks they are taking on.
“I don’t think they have a clue about the risks involved,” Dan Veru, chief investment officer of Palisade Capital Management, said in a CNBC article. “Average investors are simply out there buying yield, and they don’t care whether they’re getting it from owning lower-grade fixed-income products, dividend stocks or master limited partnerships.”
While rounding out a fixed-income portfolio, investors should consider a number potential risks that could have a negative effect on overall bond returns.
For starters, interest-rate risk stands out. Bond prices and interest rates have an inverse relationship, so bond prices fall in a rising rate environment. With rates more likely to rise than fall, the coupon rates, or interest payments, on existing bonds will be less attractive to investors. Essentially, the bonds are worth less than they once were, compared to new bond issues that come with higher, more attractive rates. [WisdomTree: Rising Rates and the U.S. Dollar]
ETF investors can determine their level of exposure to interest rate risk by looking at their funds’ duration, a measure of a bond fund’s sensitivity to changes in interest rates. For instance, a low duration of 1 year would only cause the bond fund’s price to diminish about 1% in the event rates rise 1%, whereas a long 10-year duration fund could decline 10% if rates increase by 1%. [Short Duration Junk Bond ETFs in the Limelight]
Greg Ghodsi, senior vice president of investments at Raymond James, also points out that the net asset value and return of a bond fund also dip when bond prices fall as interest rates rise. Consequently, this event may make investors nervous and fuel additional sell-offs, which can push the fund to unload more bond holdings to meet redemptions. Consequently, the fund’s portfolio can shift to lower yields or take on more risk.
Credit risk, or an issuer’s ability to repay debt obligations, is also a major factor to consider. While high-yield, speculative-grade, junk bonds provide attractive income generation, these securities come with a greater potential for defaults where the investor could lose their principle. Bond funds, though, help mitigate some default risk through holding hundreds or thousands of different debt securities. [Emerging Market Bond ETFs: Rising Credit Risk]
ETFs are only as liquid as their underlying assets, but the bond market is far less liquid that the equities market. During times of distress, corporate debt, especially junk bonds, can be difficult to unload.
Inflation can also eat away at bond investment returns. As consumer prices or inflation rises, purchasing power declines and the so-called real value of fixed-income returns also diminish. Investors can calculate their real yield by subtracting inflation from a bond’s current yield. If inflation outpaces the current yield on a debt security, the investor essentially receives a negative real yield. [Fight Back Against Inflation with TIPS ETFs]
For more information on the fixed-income market, visit our bond ETFs category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.