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Bond investing may seem intimidating but it does not have to be if a few basic characteristics are understood. The first rule in investing–which is especially applicable to fixed income investing–is that real returns cannot be had without assuming some risk. Bonds are primarily subject to three types of risk: interest rate, credit, and inflation. Each risk has a distinct implication for bonds and should be well understood before making fixed income investment decisions.

Interest rate risk
As the below graphic illustrates, bond prices and prevailing interest rates (yields) act inversely of each other. If rates increase, prices of existing bonds decrease, and vice versa. The sensitivity of any given bond to interest rate risk can be determined by looking at a measure called duration. This figure is widely reported and can be found for funds on Morningstar.com. For example, a bond (or bond fund) with a duration of eight years will see a price decline of about 8% for every 1% rise in interest rates. In general, bonds (and funds) with longer durations will be more sensitive to changes in interest rates.

Accordingly, if an investor anticipates a decrease in interest rates, purchasing longer-duration bonds would be appropriate. Conversely, shorter-duration bonds would be preferable if rates are expected to rise, recognizing that while yields will be lower, interest rate risk—and its potential to reduce the value of the bond—will be lower as well.

Credit risk
Each bond issuer—be it a government, taxing authority, or corporation—has its own risk of default, or credit risk. In general, the lower the risk of default, the lower the yield compared to other bonds of the same type, maturity, and coupon. At one extreme are U.S. Treasury securities which are considered free of default risk. The yield on Treasuries is referred to as the risk-free rate and serves as the benchmark to which all other bonds are compared. Bonds trade on a “spread” above the risk-free rate, which is a reflection of default risk. The greater the default risk, the greater the spread. For example, if a 10-year municipal bond yields 3% and the 10-year Treasury yields 2.5%, the municipal would be trading at a 50 basis point spread, or 0.5%. The lower the rating, the higher the spread required to entice investors.

It is important to note that credit risk is a subjective measure of the risk of default. Rating agencies such as Fitch, Moody’s, and Standard and Poor’s are widely relied upon for their opinion, or rating, of bonds. Those bonds that receive an “investment grade” classification are rated at BBB- or higher by Standard and Poor’s. Those rated at BB+ or below are considered “high yield” or non-investment grade. These categories of bonds are treated as distinctly different asset classes for purposes of asset allocation due to their difference in default risk. Accordingly, investors should determine the appropriate allocation of investment grade and high-yield bonds in their portfolio based on their risk tolerance and investment objective.

Inflation risk
The fixed nature of the income paid by bonds further subjects bond investors to risk associated with eroding purchasing power. If inflation rises after an investment is made in a bond, it is possible that the “real” return generated by that bond could turn negative. A real return is what is received above inflation. If a bond is purchased during a low inflationary environment and inflation subsequently increases, the real purchasing power of the bond’s fixed cash flows will be weakened by rising prices. Inflation also presents an indirect form of risk to bonds by virtue of its relationship to interest rates. Rising inflation will generally lead to higher interest rates, which in turn leads to lower bond prices. As is the case with interest rate risk, longer-term bonds have higher inflation risk than shorter-term bonds.

Investors concerned with inflation should manage the duration of their bond portfolios carefully. In addition, there are inflation-indexed securities available to mitigate inflation risk that investors can consider, such as Treasury Inflation Protection Securities, or TIPS.

With a basic understanding of these three categories of risk, an investor can begin to determine the size and nature of bond holdings in his or her portfolio, and to enjoy the diversification and income benefits that bonds have to offer. As always, investors are encouraged to work with a financial professional when formulating their investment strategy. Please contact a Financial Advisor to determine the prudent steps to position your portfolio for a changing investing environment.