In last week’s article , I discussed the different investment options that are available for individuals that are seeking income generation from their portfolio. Specifically, I mentioned that bonds are not as conservative and “risk-free” as many retail investors believe. There are many types of risks associated with them. In this week’s article, I would like to take the opportunity to go into more details about those risks.
- Investment & Inflation Risks
The simple rule in the investment industry is “high risk, high return”. When investors invest into a bond, they are willing to accept lower expected returns when compared to equities because bonds are relatively more conservative and stable. Consequently, it is near impossible to double or triple your investments over a long period of time with. If investors are seeking growth of their funds, they should select equities as their investment options.
I understand that bonds provide a secure feeling for individuals that depend on the predictable interest payments to support their retirement standard of living. However, if the inflation rate is higher than the interest rate of the bond, then it is a classic example of inflation eroding the value of your money. The bad news is that, since you are committed to holding the bond until maturity, there is nothing you can do about the situation except watch the value of your money diminish.
- Default/Credit Risk
The ability of a company to make the interest payments and repay the principal back to investors is dependent on its ability to generate positive revenue and cashflow through the sale of their products or services. The company may be performing very well at the moment. However, due to changes in external factors that are not predicted, the demand for the products or services is no longer there. These external factors include new competitors in the market, new innovations, and changes in consumers’ taste. As a result of losing demand, the company will begin to lose sales, revenue, and the ability to generate cash flow. Eventually, investors will not be receiving the interest payments and the repayment of its principal. This is when the company has officially defaulted.
The company definitely wants to avoid defaulting on the payments. Out of desperation, it will begin to liquidate its assets in an attempt to raise cash. However, bondholders may be in line behind banks and other creditors to receive the sale proceeds. Hence, there is no guarantee to how much money remains from the sale proceeds to repay the bondholders.
- Interest Rate Risk
Bonds are highly sensitive to interest rate movements. Specifically, the bond prices are negatively correlated to interest rates. As rates move up, the values go down. Since we are in an all-time low interest rate environment, there is a high probability for rates to continue moving up. More importantly, the Central Banks (The Fed and Bank of Canada) in North America have forecasted that they will raise them three to four times in 2018. Therefore, having too high of an allocation in bonds in your portfolio may negatively impact instead of adding value.
Why does the negative relationship exist? Imagine we invested into a 5-year bond at 3.00% today. One month later, interest rates have increased. A new 5-year bond is yielding 3.50% in return. If an investor wants to sell the “old” one, he would have a difficult time finding a buyer. A logical investor would not purchase a bond that provides 3.00% over five years when he/she can invest in one that yields a higher return at 3.50% over the same period of time. Therefore, the investor holding onto the “old” 5-year bond has to reduce the price of it in order to attract buyers.
- Reinvestment Risk (Cash Drag)
It isn’t cheap to invest in bonds. It usually requires a large amount of capital to invest into a bond. Consequently, an investor will not be able to reinvest or purchase another bond with the interest payments that he/she receives. This causes an event called cash drag or reinvestment risk.
For example, I invest into a $100,000 bond that yields 2.00% per year. After the first year, I receive $2,000 in interest. I am not able to purchase a bond in that small increment and would have to leave the funds in a savings account that earns almost 0.00%. This is an opportunity cost because I am not able to reinvest the interest and/or principal from a bond in an efficient manner.
- Call Risk
There are bonds in the market that are callable. Callable means that some bonds allow the company to repay the principal back to investors before the maturity date. The early repayment leads to reinvestment risk (cash drag) as mentioned above because the investor unexpectedly receives a large amount of cash inflow. This affects their budgeting plan and their ability to find an equally attractive investment opportunity. Typically, the end result is it forces the invest to leave the funds in a savings account.
- Liquidity Risk
Similar to term deposits and Guaranteed Investment Certificates, bonds are not as liquid as equities. They are usually not accessible until they mature. This creates difficulty for an investor to liquidate their position and raise cash to meet unexpected expenditures. One can definitely rush and sell the holding, but it usually means that he/she will sell it at a lower than desirable price.
- Tax Liability
It is important to note that the interest payments that the bond yields are 100% taxable. This means that every dollar and penny that you receive is subject to taxation. From a “net return” perspective (money that lands in your pocket), this may not be the most effective form of return when compared to dividends and capital gains. This is, of course, based on your personal tax situation. However, the general theory is that interest returns are less attractive than the other two forms.
I truly believe that there is a place and time for everything. Otherwise, there would not be so many different investment options available for investors to choose from. The key is to know when to use specific types during specific market conditions. Based on today’s economic outlook, bonds are not as safe as everyone thinks.
Joseph Tang is an Investment Advisor at BMO Nesbitt Burns and holds the Chartered Financial Analyst (CFA) Designation. He has been working in the financial industry for over a decade. His passion is to provide comprehensive wealth management strategies and build customized investment portfolios for his clients. He firmly believes in fundamental investing and in active management of assets by adapting to constant changing economic conditions. Furthermore, proper diversification in asset classes, industries, and countries is vital to achieve sustainable wealth for his clients in the future. Joseph Tang can be reached through his email address: [email protected]
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