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Learn To Be a Good Judge Of Bond Risk

Define Your Risk Tolerance
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Investors are constantly in search of securities commensurate with the amount of risk they are willing to take. While bonds cannot be classified as risk-free given the omnipresent potential for default, they are a contractual obligation between borrower and lender. And since bonds sit higher in a corporation’s capital structure than equity shares, they are generally viewed as more secure than common stock.

Every so often you’ll hear a commentator refer to “risk-free” yield in the market. Treasury security yields, given their backing by the “full faith and credit” of the U.S. Government, are the traditional benchmark of risk-free yield. Brokered or bank Certificates of Deposit (CDs) as well as FDIC insured savings accounts might also be lumped in with risk-free yield given their insurance backing.

To see a list of high yielding CDs go here.

The reality of the matter is that Treasuries, CDs, and banking products do bear minuscule risk, so they’re not technically risk-free. Although it would likely take a depression, war, or another severe or black swan event to precipitate default on the nation’s debt, it is a remote possibility. Some economic bears and doomsayers might say it’s a bigger possibility than most of us realists tend to state. In any case, if homeland conditions became so severe that Treasury defaults occurred or bank insolvencies became so rampant that FDIC insurance became moot, we’d likely have much bigger concerns to deal with.

So though Treasuries and FDIC-backed cash accounts do represent some of the highest levels of credit that fixed-income investors can buy, there is theoretically nothing that is rock-solid safe. There are certainly bond-types that risk-intolerant investors should feel safer with than others, but basically there is no sure-fire defense from economic armageddon.

When we scan the rest of the universe, we can easily identify pockets of the bond market that pose elevated risks for investors. High-yield or junk bonds are first on the list. Companies, municipalities, or other entities with weak or inferior fiscal positions and/or otherwise slumping revenue models are a bad place to be, especially during recessions or economic upheaval. Though default rates today are historically low, economic cyclicality has a way of catching investors off guard. Few saw the coming of the ’08-’09 fiscal or its deep, wide-ranging effects.

Lending money for decades at a time also poses risk for investors in a variety of ways. First, it’s virtually impossible to know where any company will be in 30 years time, so even if you feel comfortable going way out with an investment grade firm, it’s best not to become Rip Van Winkle for the next three decades. Investment grade companies can become junk, or worse. Second, if the oft-predicted interest rate tightening scenario finally comes to fruition, holding multi-decade bonds could create substantial opportunity cost and interim capital destruction.

Investors in insured municipal bonds may feel reassured with the credit quality of the issuer and backing of the insurance company. However, as those who loaned money to Detroit can attest, the time it takes to wind down municipal bankruptcies is lengthy. Further, despite the insurance backing, investors still have to sweat out what the courts decide. While unsecured Detroit GO investors may be made whole, if we see a spate of local bankruptcies erupting at the same time, there’s no telling if the insurers will be able to cover all the damage. The public pension situation facing Detroit is not unique.

In the end, risk management is job number one for any type of investor. Understanding the potential downside to any given security is probably more important than comprehending its potential forward value. While bonds collectively seem to exhibit much lower risks than other types of investments, they are not immune to the challenges of economic calamities, or otherwise unforeseen security specific events.

aloisi

About the author: Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

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Adam Aloisi

Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

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