Strategies for the Bond Investor

 

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There are two basic ways to increase yield. One is to buy the paper of a lower quality borrower than the U.S. government. The other is to choose paper that matures further in the future. Each of these strategies entails risks that must be managed.

Lower quality

Buying paper of lower quality issuers involves more risk for the investor because these borrowers, by definition, are more likely than the U.S. government to have a problem paying principal and interest. The probability of non-payment is typically referred to as “default risk” or “credit risk.” This risk can be minimized by purchasing investment grade instruments, as defined by the major rating agencies such as S&P and Moody’s.

Longer maturities

Buying paper that matures further in the future usually (though not always) results in higher yields. This strategy, however, can expose the investor to significant drops in value even if the borrower is high quality. This is because a general rise in interest rates will cause longer maturity paper to drop in price more rapidly than short-term paper, overwhelming the positive effects of a higher yield. The following chart illustrates this tradeoff, assuming a one percent general rise in interest rates.

If you choose this maturity U.S. government bond 2 yrs 5 yrs 10 yrs
Your current yield is approximately (1Jul03) 1.31% 2.44% 3.55%
If interest rates rise by 1%, then ...
  Your yield will be this much higher than the 6-mo T-bill ... 0.36% 1.49% 2.60%
  But the bond price will drop this much more than the T-bill* ... -1.96% -4.03% -7.7%
  So you will be worse off than the T-bill by ... 1.60% -2.54% -5.10%
 
* Rough estimate using modified Macaulay duration. For illustrative purposes only.

The tendency of bonds to drop in price when interest rates rise is commonly known as “interest rate risk.” Professional bond portfolio managers typically manage this risk by using “bond duration” and other quantitative approaches to measure and limit the sensitivity of the portfolio to changes in interest rates.

Such a drop in price can be disquieting but largely academic for investors intending to hold the paper, since they eventually will receive the face value of a bond (assuming the issuer remains creditworthy) at maturity.

Sumner Gerard, CFA
July 2003