Understanding risks // Evaluating your portfolio // Taking action
The markets today present investors with challenges – interest rate and credit risks in particular – that should be considered when evaluating income-producing investments. Rising interest rates in the future can have a dramatic impact on the value of these investments, but there are strategies available to help you manage those risks. It’s important to understand which types of risk you are more comfortable with, as there are tradeoffs with every decision you make in your portfolio.
When you meet with your financial advisor to discuss these realities of income investing, be sure to address these four key questions:
- What do I own and why – what role do income-producing securities play in my portfolio?
- What will happen to my portfolio if interest rates rise in the future?
- What other risk exposure do I have?
- What action should I take to mitigate risks and still achieve my goals?
It’s important to understand the various timely risks to income investing – such as rising interest rates – and the impact they can have on your portfolio.
The key to properly evaluating the impact of these risks is to understand the various income-producing securities you own and why you own them.
Work with your financial advisor to assess the role of income producing investments within your overall financial plan and consider strategies available to achieve your goals while managing associated risks.
1. WHAT DO I OWN AND WHY?
Individual bonds have long been the traditional option for fixed income, but these days bond mutual funds and closed-end funds are also popular choices for purposes of professional money management and diversification. Bonds may also be purchased as part of a separately managed account (SMA), through which portfolio managers select bonds to be owned by the investor directly.
Once you identify the bond holdings in your portfolio, it’s important to understand why you own them. For example, you may include bonds in your portfolio for:
- Predictable income
- Diversification from equities
- Preservation of capital
- Total return opportunities
Depending on the specific role these investments play in your portfolio, the associated risk factors will have a different impact on your decision-making process.
Sample investments in bonds
Bonds: Credit rating, coupon rate and maturity date are generally set when purchased, with 100% of money invested and earning interest.
Bond funds: Typically pay monthly distributions that vary based on the types of securities the fund’s manager buys and sells, the amount of cash held in the portfolio, and flows into and out of the fund.
Closed-end funds: Payments vary based on bonds and other investments that the fund’s manager buys and sells, cash held (though typically fully invested) and current market rates. Closedend funds that use leverage can increase losses.
ETFs: Traditional, index-tracking exchange-traded funds provide income similar to the index being tracked.
Since bond funds, closed-end funds and ETFs do not mature and their prices change daily, it is impossible to predict the value of an original investment at the time of sale.
FINRA WARNING TO INVESTORS
The Financial Industry Regulatory Authority (FINRA) is a private, non-governmental agency that regulates its member brokerage firms and the financial markets. Its mission is to protect America’s investors by ensuring the securities industry operates fairly and honestly. As part of this effort, FINRA regularly issues explanations on how current market conditions may impact investors. The following excerpt is from a recent commentary on the impact of rising interest rates on fixed income investors:
“Currently, interest rates are hovering near historic lows. Many economists believe that interest rates are not likely to get much lower and will eventually rise. If that is true, then outstanding bonds, particularly those with a low interest rate and high duration, may experience significant price drops as interest rates rise along the way. Investors who have money in a bond fund that holds primarily long-term bonds can expect the value of that fund to decline, perhaps significantly, when interest rates rise.” (02/14/13)
2. WHAT WILL HAPPEN TO MY PORTFOLIO?
If economic conditions continue to improve, interest rates are likely to rise. Although traditionally serving as a safe part of a portfolio, bonds do pose risks in a rising interest rate environment. For example, when interest rates rise, bond prices typically decline. Another issue to consider is that the higher the duration of a bond, the greater its price sensitivity to changes in interest rates.
If you own individual bonds to receive steady, consistent income, you may not be as concerned about changes in the value of your bonds since they will continue paying out income subject to the creditworthiness of the issuer. However, if you are instead using bonds to achieve an attractive total return, you may want to reposition assets to help you better achieve this goal, since your bond values may drop as interest rates rise.
Work with your financial advisor to help you understand the role fixed income investments play in meeting your objectives.
How do higher interest rates affect bond duration?
Duration is quoted as the percentage change in price for each given percent change in interest rates. For example, the price of a bond with duration of two would be expected to decline by about 2.00% for each 1% move up in rates.
3. WHAT OTHER RISK EXPOSURE DO I HAVE?
It is important to understand that there are tradeoffs with every decision you make in your portfolio, as you may find yourself trading one risk for another. For example:
- Shorter maturity bonds of similar qualities will typically have a lower yield
- Higher-yielding bonds of similar maturities generally present higher credit risk
- Non-dollar investments, such as foreign bonds, carry currency and geopolitical risks
How certain risks will impact you differs depending on your objectives and the types of investments you own. The accompanying table details additional risks associated with income investing.
There are numerous other risks that you should be aware of when investing in securities designed to provide income.
Purchasing power risk:
Over time inflation may lower the value of returned principal. This means an investor will be able to purchase less with the proceeds received at maturity. Higher inflationary pressures usually result in higher interest rates.
Those who lock in their returns by investing in long-term bonds might not be able to reinvest at higher rates when rates go up. However, those who buy short-term securities or callable securities may face the risk of having to reinvest at lower rates when interest rates drop.
Additional risks include, without limitation, liquidity, currency fluctuations, differing accounting standards, political and economic instability, and differing tax laws. Investors may benefit from professional management.
Not suitable for all investors. The risk of default may increase due to changes in the issuer’s credit quality. Price changes may occur due to changes in interest rates and the liquidity of the bond. When appropriate, these bonds should only comprise a modest portion of a portfolio. As with foreign bonds, investors may benefit from professional management.
4. WHAT ACTION SHOULD I TAKE?
Work with your financial advisor to forecast “what if?” scenarios and gauge your comfort level with different possible outcomes. Start by confirming why you own income-producing investments, the role they play as a part of your overall asset allocation and evaluate your risk tolerance in view of the risks that may be present going forward.
Your advisor can run an analysis on any individual bonds you own to assess their credit quality, exposure by credit rating and diversification across issuers. He or she may be able to use this analysis to quantify the potential impact of rising interest rates on the value and total return of your individual bond holdings.
Together, you can determine whether your current holdings are aligned with your investment objectives or if changes may be prudent. While we do not recommend dramatic changes to asset allocations based upon day-to-day market movements, there are a number of strategies available that may help manage long-term risks such as:
- Lowering the average duration of your investments
- Improving the credit quality of your investments
- Diversifying across different types of income-producing investments and issuers
- Reducing bond exposure in favor of alternative asset classes
Work with your advisor to forecast “what if?” scenarios and gauge your comfort level with different possible outcomes.
REVISIT INCOME GOALS AND STRATEGIES
Due to actions by the Federal Reserve, rates may not increase in the immediate future and many of the risks discussed herein may not present themselves for months or even years. However, in view of where we are in the interest rate cycle and the broader economic recovery, now is an opportune time to evaluate your portfolio and determine if action is warranted.
Your financial advisor possesses the tools, resources and expertise to help you make informed decisions. While drastic changes may not be necessary in your portfolio, it’s important to discuss these risks with your financial advisor now and take necessary steps to ensure you are well positioned for any scenario.
Work with your financial advisor
- Understand the products you own and the risk profile associated with each
- Reaffirm why you own bonds and the role they play in your overall portfolio and financial plan
- Re-evaluate your risk tolerance and understand the risks currently facing income investors
- Forecast potential scenarios and the impact on your portfolio
- Identify and implement appropriate strategies to manage risks
Talk with Summit Wealth Strategies today to learn more about income investing.
Asset allocation does not guarantee a profit nor protect against loss. A credit rating of a security is not a recommendation to buy, sell or hold securities and may be subject to review, revisions, suspension, reduction or withdrawal at any time by the assigning rating agency.
Raymond James financial advisors do not render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional.
There are numerous other risks you should be aware of when investing in fixed income. For detailed information on factors to consider when investing in bonds, visit: http://raymondjames.com/fixed_income_bond_investing_risks.