by James Copenhaver, Director of Investment Management, Wealth Enhancement Group

Last month, we provided a brief overview on the fundamentals of fixed-income securities. Specifically, what bonds are and why their yields rise and fall inversely with their prices. In this article, we will take a closer look at some key issues that concern bond investors.

An important, albeit somewhat esoteric, aspect of bond investing is the measurement known as duration. Say you purchase a Treasury bond while a friend purchases an equivalent zero-coupon bond. You would pay the face (par) value of the bond and receive semi-annual dividend payments each year. Your friend does not receive any dividend payments but is able to buy the bond at a discount to par value. Both of you receive the par value of the bond at maturity. What would happen to the prices of these two bonds if interest rates were to significantly rise? The difference lies in the fact that your friend will receive one lump sum payment several years down the road. You, on the other hand, will receive consistent dividend payments along the way that you could invest in higher yielding bonds as rates go up. This inability to reinvest more quickly at higher rates makes zero-coupon bonds more unattractive than coupon bonds in a rising interest rate environment.

Consequently, in this example, the price of your friend’s zero-coupon bond will fall more than the price of your coupon bond. This difference in sensitivity to interest rates is known as “duration.” Duration is a critical factor in bond investing because it gives an indication of how a specific bond’s price is expected to react with changes in interest rates. Using duration as a guide, investors can construct a portfolio based on their expectations of future interest rate movements: they would prefer lower durations (less sensitivity) with rising interest rates and longer durations (high sensitivity) with falling interest rates.

Another key element in fixed-income investing is interpretation of the yield curve. and where to position one’s investments on the curve to take advantage of expected interest rate changes. The yield curve is a graph that plots the yields of bonds (typically Treasuries) of different maturities. The plot shows yields on the vertical axis and maturities on the horizontal axis. In general, one would expect the yield curve to have a positive slope; that is, yields increase as maturities lengthen in order to compensate investors for the longer wait until repayment of principle. However, over time the yield curve will actually change shape based on investors’ outlook of the economy. For example, a future recession is typically predicted by an inverted yield curve; in a recession interest rates usually decrease and this is reflected in the yield curve by longer dated maturities actually offering fewer yields than shorter dated maturities.

There are a myriad of other risks that fixed-income investors must consider when selecting investments. Default risk is the risk that the issuer will stop making interest payments and not return principle at maturity. Issuers with higher risk of default are usually forced by investors to offer a higher yield on their bonds to compensate for the increased risk. Bonds considered to be “investment grade” are viewed to have less default risk than higher yielding “junk bonds.” Investors must also be aware of inflation risk, reinvestment risk and liquidity risk, among others.

Fixed-income securities can be a critical component of an individual’s overall portfolio. For individual investors considering bond investments, the complexities of portfolio management and access to bond securities make the consideration of professional management a worthwhile consideration.