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Bond Funds: How to Use Diversification to Minimize Risks

It’s hard for individual investors to trade bonds profitably, as there is little standardization, there are no public exchanges, and the market can be opaque.

Articles by Dan Egan
By Dan Egan VP of Behavioral Finance & Investing, Betterment Published Jun. 10, 2015
Published Jun. 10, 2015
9 min read
  • It’s hard for individual investors to trade bonds profitably, as there is little standardization, there are no public exchanges, and the market can be opaque.

  • Bonds typically face two primary kinds of risks: interest rate risk and credit risk.

  • Bond ETFs allow investors to more easily diversify bond risks.

Bond trading has long been the domain of institutional investors, but the advent of ETFs has allowed for retail investors to better access the space.

Unlike most stocks, which are standardized and bought and sold on public exchanges, most bonds are traded over the counter: two parties negotiate the price directly. This lack of standardization and transparency makes it more difficult for individual investors to trade bonds in comparison to stocks.

Now, with the arrival of bond ETFs that track transparent indices, bond trading has become more accessible to individual investors. But, it comes with a caveat: individuals who attempt to tactically trade bonds or bond ETFs should understand that bond market timing is difficult. In fact, it’s possibly more difficult than stock market timing.

The Difference Between Stocks and Bonds

Before we delve into bond ETFs, it’s critical to understand the distinction between bonds and stocks. When an entity—such as the federal government, a company, or even a municipality—issues a bond, the bond issuer is borrowing from bond holders. An investor who buys a bond is effectively a lender. In contrast, stock investors own shares of the company.

While a bond purchase does not confer ownership, bond buyers get paid a regular coupon (often a fixed semiannual interest payment determined at issuance) to compensate them for the use of their money. This is also compensating them for the risk of default, which is the chance that these investors won’t get their money back. Unless there is a default, bond investors can expect to get a regular income payment until the bond matures, at which point the bond returns its principal. In the event of a bankruptcy, bondholders’ claims have priority over stock shareholders for any remaining value of the company’s assets.

With this security, and because of the regular income stream in the form of coupon payment, bonds are generally considered less risky than stocks. However, there are also bonds that pay zero coupons, the holders of which get their entire payment at maturity. It’s also one reason zero-coupon bonds are often considered riskier than regular bonds. As a result, zero-coupon bonds typically trade at a discount because they lack a regular coupon payment and experience more volatile price fluctuation compared with regular coupon-paying bonds.

Two Types of Bonds Risk

While bonds may be less risky than stocks, they still carry risks. Two major bond risks are interest rate risk and credit risk.

1. Interest Rate (or “Duration”) Risk

Interest rate risk applies to all bonds, and it is the risk that stems from the sensitivity of bond price to rate fluctuations. When the market expects interest rates to rise, bond prices fall. And bonds with greater duration are more sensitive to these expected interest rate changes. The higher this sensitivity, the more the bond’s price will fall for a given expected interest rate rise.

When the market expects interest rates to rise, bond prices fall. And bonds with greater duration are more sensitive to these expected interest rate changes.

The inverse relationship between interest rates and bond prices can be confusing, so we’ll go through examples using a rising rates environment and then a falling rates environment to make the mechanics clear.

For simplicity’s sake, let’s assume that there’s a zero-coupon bond trading at $980 and has a par value (value at maturity in one year) of $1,000. The bond’s rate of return is 2%, or ([1000-980]/980)=2.04%. A person who wants to buy this bond believes that a 2% return is a good return. But the attractiveness of the bond is not solely determined by the bond itself. The broader interest rate environment is critical to determining how attractive this particular bond is in relation to other bonds and floating-rate savings accounts in which he can invest.

If interest rates were to rise, providing investors a 3% risk-free rate, then the bond yielding 2% would seem less attractive, and it would take a really great bond salesman to get rid of that bond at $980. The 2% bond pays a lower return and carries the risk of having even lower relative return in the future. To create demand for this bond, the price of the bond would have to drop to $971, at which point the bond would yield 3%, and only then would the bond be as attractive as other bonds.

Conversely, if rates were to drop to 1%, the bond that pays a 2% yield would suddenly become very attractive because it’s difficult to find bonds that have a yield as high as the 2% bond. Demand for that bond would increase, and the price of the bond would be pushed up to $990, at which point the bond’s yield is 1%.

You can think of price and yield as variables that change to help bonds achieve equilibrium with the rest of the interest rate market. In short, the desire for comparable yields force bond prices to change. From a coupon perspective, bonds with less attractive coupons are priced at a smaller discount to incentivize investors. Conversely, bonds with more attractive coupons can afford to be priced at a larger discount and still be attractive to investors.

So one bond risk is duration, or how long you’re exposed to potential interest rate changes. Duration is conventionally expressed in years. The longer your bond has until it returns its principal, the more time it has for better interest rates to drive its price down.

Although it’s stated as a measure of time, it is also a measurement of how much the price of your bond will change as a response to rate fluctuations. The longer the duration, the more pronounced the price change.

Duration is best illustrated by an example. If rates are expected to rise 1%, bonds with a duration of one year will have a 1% decrease in price. In contrast, bonds with a duration of five years would have a price decrease of 5%.

Price Reaction to Expected Rate Change By Duration

Duration (in years) -3% in rates -0.5% in rates +1% in rates
1 +3.0% +0.5% -1.0%
2 +6.0% +1.0% -2.0%
3 +9.0% +1.5% -3.0%
4 +12.0% +2.0% -4.0%
5 +15.0% +2.5% -5.0%

There is a common misperception that holding a bond to maturity makes your portfolio immune to interest rate risk. The reality is, when rates rise, the total expected return from a bond is identical, regardless of whether the bond is held to maturity or sold at a loss and replaced with a bond that pays a higher coupon. This is largely because of the fixed nature of a bond’s coupon, which is determined at issuance.

To be as attractive as new bonds with higher coupons to investors, the only other variable that can change for a bond is the bond’s price. Lower-priced coupon bonds are priced lower to attract similar investor demand. If, after an interest rate rise, you were to sell your bond at a loss, you would be able to immediately purchase a bond with the same yield as the new bonds with the higher yield. In fact, you could tax loss harvest after a rate increase, yet still have the same yield from your portfolio

2. Credit Risk

The second risk inherent to bonds is credit risk, or the risk that an entity will default by either not paying its coupons or returning principal. Credit ratings agencies, such as Fitch and Moody’s, provide ratings on individual bonds. Issuers with worse credit ratings, viewed as more likely to default on their bond payments, pay higher “spreads,” or premiums, over the interest rate offered on a risk-free bond ( U.S. Treasury bonds) to incentivize investors to take on the higher credit risk.

To give an example of how credit risk figures in the price of a bond: 5-year Treasuries yielded 1.57% as of May 21, 2015. Apple Inc. bonds of similar maturity, those maturing on May 6, 2020, yielded 1.99%. The extra 42 bps (bps = basis points; 1 basis point = 0.01%) of spread above the Treasury rate are the extra compensation given to Apple investors for the slightly higher risk that Apple carries over treasuries of equal maturity. Although Apple bonds maturing in 2020 are rated Aa1 (which suggests that the company is of very high quality and low credit risk), high-quality corporate bonds still carry a premium over similar maturity treasuries.

Compare the thin credit spread of Apple bonds to the larger spread of a lower-rated company, Caesars Entertainment Corporation. Caesars is a casino and entertainment provider that has a B2 rating from Moody’s, which classifies it as speculative grade with significant credit risk. Caesars bonds maturing on October 1, 2020, yield about 7.06%. Despite the similar maturities of Apple and Caesars bonds, Caesars bonds yield 5.07% more because of the company’s higher credit risk or probability of default.

Note that the same Caesars bond that yields 7.06% pays a coupon of 8.00%. While bond coupon and yield are related, they are not identical. The coupon is a periodic interest payment that’s fixed at issuance, while the yield is a measure of an investor’s expected return, which includes the coupon but also any change in bond value or its market price (except for “current” yield, see details below).

Bonds by Maturity, Rating, and Yield

Bond Maturity Rating Yield
5-year Treasury 5 years AAA 1.72%
Apple 5 years Aa1 1.99%
Caesars 5 years B2 7.06%

Source: TRACE and Treasury.gov

As demonstrated by Apple Inc. and Caesars, the higher the credit quality, the thinner the spread. In other words, higher quality bonds can afford to pay less and still attract investor interest. So the next time you are tempted to buy “high yield,” consider the higher probability of default associated with that higher yield. In fact, many distressed companies have a yield above 10%. This level of yield, though attractive, should immediately raise a red flag about the odds of getting your principal back.

When credit ratings change—or when entities (companies or sovereigns) are upgraded or downgraded—it also changes the credit spread for those bonds. When a company’s credit rating is downgraded, the spreads widen. When the credit rating is upgraded, the spread compresses. Bonds that cross from an investment grade (Baa3 and above) to high yield (below Baa3) are called “fallen angels.” Studies have shown that fallen angels tend to carry a higher yield than similarly rated bonds issued by companies that have the same rating from the beginning.

Additionally, some investment funds place restrictions on the credit ratings of bonds that they can hold in the funds. For example, some funds—like those operated by pensions or insurance companies—restrict bond holdings to those that are rated AA or higher. This is one way to lower risk in the funds’ bond basket for investors.

Bond and Bond Funds

Bond mutual funds and ETFs offer increased liquidity and diversification that investors can’t access with individual bonds. These benefits hold true even in a changing rate environment. A single intermediate term bond may suffer from interest rate increases because of the inverse relationship between price and yield, but a diversified bond ETF basket can help insulate against rate risk.

Consider the fact that “more than 90% of the total return since 1976 generated from a broadly diversified portfolio of U.S. investment-grade bonds has come from interest payments, not change in price.”¹ The compensatory effect occurs because higher interest rates translate to issuance of new bonds with higher coupons. So while the price of the bond fund may drop because of the expectation of rising rates in the short to intermediate term, this helps bond ETF investors in the long run, as the higher coupons more than compensate for the decrease in price.

If you hold a well-diversified portfolio of bond ETFs, your bonds will most likely be diversified in several dimensions: quality, geography, maturity, and duration.

If you hold a well-diversified portfolio of bond ETFs, your bonds will most likely be diversified in several dimensions: quality, geography, maturity, and duration. Each of these dimensions helps bond ETFs to insulate against the deleterious effect of a rate increase on bond value.

Quality Diversification

Lower-quality bonds have higher spreads, and the wide spread can often act as a buffer against rate increases. In addition, as rates increase, credit spreads tend to compress.  In some quality spectrums, the compression overcompensates the rate increase, resulting in a lower overall yield and a higher overall price. In effect, the compensatory action of spreads insulates the impact of rate hikes.

Geographical Diversification

Similarly, holding a portfolio of geographically diversified bond ETFs prevents you from falling prey to home bias. Because interest rates are dependent on the monetary policies of different countries, it’s unlikely that all countries would decide to increase interest rates at the same time. For example, in 2015, strong growth in the United States set the stage for a rate hike, but the European Central Bank and the Bank of Japan have cut their interest rates to stimulate their sluggish economies. Developed markets, such as Australia and Sweden, as well as emerging market countries, such as Brazil, India, China, and Russia, have slashed key interest rates, many for multiple times. Owning a bond portfolio consisting of bonds from different countries helps to mitigate interest rate risk because it’s rare for independent monetary bases to act in tandem.

Maturity Diversification

Further, the shape of the yield curve moderate the impact of rates on a bond ETF. Interests rates for short-, intermediate-, and long-term bonds may react very differently to a change in monetary policy depending on market expectations. Often, lower maturity bonds will react more than long term bonds to rate hikes. During the 2003 cycle, because long-term inflation expectations were stable, long-term rates stayed anchored while short-term rates rose.

You may think that, with a rate hike almost certainly coming, steering away from bonds in favor of cash or stocks can reduce the impact of rate hikes on bond portfolio returns. The reality is, often by the time that individual investors decide to take this view, the market has probably already priced in a rising rates outcome. This makes it difficult for retail investors to get a competitive advantage in reallocating ahead of rate hikes.

Betterment’s Portfolio

A Betterment portfolio allows you to diversify your bonds along all these aforementioned dimensions. The bond portfolio is not only diversified in terms of quality, but it’s also diversified in terms of geography and maturity. Our portfolio allows you to own bonds from more than 20 different countries. A Betterment bond portfolio spans all ratings categories, from bonds rated AAA to bonds rated “Below B.” Further, it allows you to be invested in all maturity buckets, from short-term obligations with a term of one year or less, such as T-bills, to long-term bonds, such as the 30-year Treasury. The charts below show how a 70% bond 30% stock portfolio is diversified along the three dimensions of quality, maturity, and geography.

Bond Diversification by Quality, Geography, and Maturity

Owning a diversified portfolio of bond ETFs allows you exposure to a wide range of maturities, geographies, and durations. In the context of a rising rates environment, holding bond ETFs for the long term remains a compelling investment strategy.

¹Williams, Rob. “Should You Worry About Bond Mutual Funds If Interest Rates Rise?” Charles Schwab Insights. 16 Sept. 2014. Web. 22 May 2015.

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