Many investors think of bonds as “safe”. That’s not really a good idea. Bonds are “safer” compared to some other investments, but not as safe as others. In a period of unprecedented market changes, where the bond market has been manipulated by the Federal Reserve’s quantitative easing program, understanding bond risk is very important. In this short series of articles I will cover the five types of risk inherent in bonds.
Our first topic is Maturity Risk. Just about every fixed income security is called “fixed income” because the investment pays a fixed rate of interest on the principal amount until a bond matures. Available maturities range from 30 days all the way up to 30 years.When you buy a bond, you are taking a risk that the interest rates may change during the time you hold that bond. Buying a bond with a longer waiting period to maturity increases that risk, since it increases the chance that interest rates could rise over that period.
So if you buy a 30-year-bond that pays, say, 6%, you may think of yourself as a genius. But if interest rates pop to 15% or higher (as they did in the late 1970’s), then you will be kicking yourself.
Alas, if you buy a short-term bond to reduce the chances of this happening, you aren’t taking much risk, so you won’t earn much yield. That’s why it’s a good idea to be diversified.
Something called “maturity risk premium” is the extra yield – the premium — you earn from buying a bond with a longer time to maturity.
This notion of maturity risk premium exists any time you have an investment that pays a fixed rate of interest and has a fixed maturity date. Is there some way to quantify maturity risk premium, so you can compare apples to apples? Yes. This risk premium can be quantified by comparing your chosen investment across investments with different maturities.
So let’s say your bank pays 1% interest on a two year certificate of deposit and 3% percent on a six year certificate of deposit. You earn an extra 0.5% percent per year for keeping your money in the longer term CD.
We see a real-world example b looking at government bonds. The yield on the 20 year Treasury is 2.33%. The yield on the 30-year bond is 2.59% percent. Is it worth it to you to earn an extra 0.26% per year for giving the government a loan for those extra ten years?
Now, how can you assess maturity risk premium if you don’t know which way interest rates may go? That’s the trickiest part of the deal. What we do know is this: interest rates are pretty much at all time lows. They are more likely to rise than fall at this point.
Consequently, you should be careful about locking yourself in to long-term maturities in the present environment. That’s why many managers suggest you build a “bond ladder”. That’s where you buy bonds with different maturity dates that “ladder” their way out in tome – bonds that mature in 2 months, 3 months, 4 months, 1 year, 2 years, and so on.
As maturity dates arrive, you roll over the bond and buy it again at the same maturity. If interest rates have changed, you’ll be taking advantage.
Next time: Credit Risk.
About Lawrence Meyers – Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at [email protected]