Investment Risks in Fixed Income Products
One of the key things to understand when investing in fixed income products is risks associated with this asset class. Contrary to popular notion, fixed income products are not devoid of risks and you need to be aware of them before investing in these products.
Investment risks: The Basics
Risks fall under two broad categories â Systematic risk (also called Market Risk and cannot be mitigated) and Unsystematic risk (this can be mitigated through appropriate portfolio strategies). Systematic risk impacts the entire market. Examples of this include change in government policies. Unsystematic risks are specific to a particular investment and can be mitigated through portfolio diversification. Within a fixed income portfolio, you can diversify your holdings across a number of products and minimize the risk. We will look at the unsystematic risks and see how you can avoid some of them.
Sources of Risks in Fixed Income Asset Class
Interest rate risk: This is caused by movements in interest rates. The value of bonds is inversely correlated to the interest rate and hence an upward movement in interest rates in the market will cause the value of bonds to dip. The Federal Reserve is holding the interest rates low for a prolonged period to spur credit demand in the economy. Once there are visible signs of the economy picking up, the Fed will announce an increase in policy rates which would cause the prices of bonds to decline. While you continue to receive your periodic interest payments on the bonds, the capital value of the bonds that you hold would decline, causing a capital loss. However, if you hold the bonds to maturity, you will not suffer a capital loss, as the bonds would be redeemed by the issuer at the face value.
Re-investment risk: This is the risk that you may not be able to reinvest the proceeds from an earlier investment at the same rate (as the original rate) at the time of maturity. If interest rates go up, you would gain and lose out in a declining interest rate scenario. You have to consider this risk when the maturity profile of the instruments you hold is less than your time horizon for investment. Laddering is a popular technique that helps reduce re-investment risk. What you should do is to invest your money in a staggered manner and vary the maturity profile of your investments. This would help you ride out the volatility on the interest rate front.
Liquidity risk: This is the risk that you may not be able to sell your holdings when desired. Or you may end up selling your holdings far below their intrinsic worth. Certificate of Deposits come with definitive lock in and are not liquid instruments whereas bond funds can be bought and sold on the exchange and carry minimum liquidity risk (the bond funds that are listed heavily traded). Always keep in mind your liquidity needs when you decide to allocate your funds to fixed income instruments.
Exchange rate risk: You would be exposed to exchange rate risk when you invest in instruments denominated in a currency, different from your domestic currency. You may find interest rates attractive in emerging economies and choose to invest in bond funds that hold these securities. What you should also remember is that this investment has an inherent risk of currency exchange rates. During uncertain times, an adverse currency exchange rate movement may offset the interest you earn and even cause a capital loss. One way of mitigating this risk is through currency hedges; however, these instruments are not available to all. And the cost of these hedges may outweigh the returns and make the whole exercise not worthwhile.
Credit risk: This is the risk that the issuer of the instrument may default on the obligations to pay the periodic coupon payments and/ or the principal. You should look for those instruments that carry a high credit rating and not get swayed by attractive coupon on offer. Instruments with good credit ratings carry a lower coupon as a general rule. Sticking to highly rated securities would protect you from this risk.
Summary
If you are looking at building a fixed income portfolio, it would be worthwhile to understand that this asset class is not devoid of risk. The objective of fixed income investing should be to generate steady income without taking undue risks. And understanding the risks in this asset class and ways of mitigating them would help you plan your allocation to this asset class.
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Author Bio:
George is a full time financial adviser and blogger. His interest lies in trading, investment, portfolio management and business finance. He also owns a couple of finance blogs which provide valuable information to intellectual readers.
–ME “Liz” Strauss
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