Where Are the Hidden Risks in Your Bond Portfolio?

Expert Contribution by Brian McGeough, Chatham Wealth Management

The biggest current risk to both stocks and bonds is rising rates. Bond yields have fallen since the early 1980’s (see chart below). We do not expect a precipitous move to higher rates, but we have experienced long periods of rising rates before (see 1960s thru early 1980s below) and we should be prepared should rates move higher over time.

Bonds perform a valuable role within portfolio construction. They add stability and income. I have been in the bond business for 30+ years and this current environment for bonds offers the worst risk return profile I have seen. This does not mean you shouldn’t own bonds, but you need to be very selective and buy the right type of bonds so that they offer a safe haven in times of increased volatility.

Risks

Credit spreads are very tight. What does this mean? The incremental yields offered for high quality corporate or municipal bonds are at historic lows or stated another way, investors are being paid less than ever to take on additional risk.

With the yield curve relatively flat, you are not being adequately compensated to go further out the maturity spectrum. The longer the maturity a bond has, the more sensitive to a change in interest rates (duration risk). If interest rates rise by 100 basis points (1%), a bond with a seven-year maturity will fall more than -6% in price. Conversely, buying a bond with a two-year maturity will have only 30% of the price sensitivity of the seven-year bond, but provides with 90% of the yield.

Given tight spreads and not being paid for incremental duration risk, how do you want to position yourself?

• Avoid longer dated bond mutual funds – knowing when you are getting your money back is imperative

• Construct a bond portfolio of shorter duration and higher quality bonds with less interest rate sensitivity

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