Celia Cazayoux, a senior portfolio manager at People's United Bank, appeared on the Channel 3 Morning News to talk about bonds.
What do investors need to know and understand about their fixed income investments as we enter 2013?
· For many investors, the fixed income (or bond) portion of their portfolio has generally served two purposes:
1. To generate income and
2. To serve as a cushion against the volatility of the equity portion of their portfolio.
And, it has generally been considered to be the low risk part of the portfolio.
· However, with today's low interest rate environment, we find that bonds aren't generating much in the way of income and, perhaps more importantly, with the prospect of rising interest rates on the horizon, many investors may find that the bond portion of their portfolio has more risk than they realize.
What kinds of risks are associated with bonds?
As with any investment, there are risks. With bonds, the primary risks are
· Credit Risk: The risk that a company defaults and an investor loses some or all of their investment. This is associated with corporate bonds as opposed to US Government Treasury bonds.
· Interest Rate Risk - This risk impacts all bonds. As interest rates rise, the price of a bond declines.
· Inflation Risk - The risk that the return generated from the bond doesn't keep pace with the rate of inflation.
Historically, most investors have considered credit risk, or the risk of default, to be the primary risk in their bond portfolio. Investing in bonds with a low risk of default - often US Government Treasury securities - was a way to mitigate that risk. (Even with the current debate in Washington, we still expect the US Govt to make good on its obligations).
In today's environment, however, we think investors need to be more aware of the other risks…interest rate and inflation risk. These risks are actually greater in those "safe", low credit risk bonds I just mentioned.
Why is that the case?
· US Government Treasury yields are at historically low levels today in part as a result of the Federal Reserve's actions to spur economic activity by keeping borrowing costs low.
· The yield on a 10 year US Treasury bond is actually less than the current rate of inflation, so an investor who buys this bond would essentially be locking in a loss on his investment after inflation.
· Secondly, as interest rates rise - which we do expect to happen - bond prices decline. Bonds that have very little yield associated with them - like a US Treasury - could generate negative returns when rates rise as there's not enough income being generated to offset the decline in price.
· So, yesterday's "safe" bond is becoming today's "risky" bond.
In light of this, do you still recommend bonds for your clients?
· We do believe that bonds represent a core component of a diversified portfolio for the long-term investor.
· We generally recommend a diversified mix of fixed income assets for our clients and we look to balance that need for income and real return with acceptable levels of risk.
· Today, we prefer to take on credit risk over interest rate or inflation risk. Given the current interest rate environment, we think investors need to review their holdings and re-evaluate their own perceptions about risk in their bond portfolios.