Government agencies, exchanges, major bond investors, and main street investors are again preparing for the long awaited upward shift in interest rates and a potential collapse in bond market prices and liquidity. Deja vu, right? Know your risk exposures and understand the location of your hard earned dollars!
Here are nine not-so-obvious risks to evaluate in your bond exposures:
1. The “bond” label is not always synonymous with conservatism or lower risk. The opening graphic plots daily percent yields for the “risk-free” US 10-year bond from 6/19/2014 to 6/19/2015. Price movement in this key benchmark rate is likely to experience historic volatility in the future. Other segments (high yield, municipal, emerging, mortgages) of the bond market are smaller and less liquid than treasuries.
2. Principal, maturity, and credit features are not guaranteed or insured. Many investors do not realize, understand, or appreciate that bond funds can fall in price. Bond funds are not insured or guaranteed by FDIC, the U.S. Securities Investor Protection Corporation (SIPC), or by any other government agency, regardless of underlying holdings, or how a bond fund is purchased or sold—whether through a brokerage firm, bank, insurance agency, financial planning firm, registered investment advisor, or directly.
3. A net asset value (NAV) of fund shares is no guarantee. The ability to sell fund shares on any business day does not necessarily translate into the characteristics of “liquidity.” Funds make pricing assumptions, and they can receive much lower prices when they actually sell their holdings. Note: closed-end bond funds trade at premiums and discounts to their underlying NAVs.
4. Embedded leverage is the proverbial double-edged sword. Funds use yield enhancement strategies to try and boost returns and market their portfolios to attract or maintain investors’ money. This activity can translate into less obvious risks.
5. Is the Fund 100% committed to owning actual bonds? Whether due to fund size or purposeful strategy, additional risks are introduced with the use of synthetic positions and derivative contracts rather than actual bonds.
6. Date & data matching on fund report cards. Always check the “as of” date on top holdings, risk metrics, returns, credit weightings, and asset breakdowns. Look closely, and you may see inconsistency with the published report issue date. Are you sure you know what you own?
7. Fund managers may invest outside their comfort zone. Unprecedented low rates and high prices have forced some fund managers to reach for yield outside their comfort zones or core competencies. For example, a “conservative” fund could have heavy exposures to potentially high-risk Puerto Rico and tobacco bonds.
8. Risk metrics can be misleading. Listed durations are very popular and convenient numeric gauges of interest-rate risk. Unfortunately, these generic stand-alone descriptions of price sensitivity can mislead investors due to straight-forward assumptions and limitations. Most bond funds consist of hundreds or even thousands of bonds across a spectrum of maturities, sectors, credits, and bond features–so accurately portraying a full portfolio’s risk is more complex.
9. Historical “average” returns should not be extrapolated into the future. The chart below shows a clear example of unprecedented U.S. Central Bank activity beginning in 2008, when the Federal Reserve began increasing the size of its balance sheet from $900 billion to $4.5 trillion. Translation: Objects as seen in the seven year rear-view mirror are very distorted.