Sunday, August 12, 2012

The big question: Risk vs Return, Part 4

In this post, we'll discuss the risk involved in bond investment.

Bonds are fascinating! They really are. Different to how most stocks' return comes from appreciation (price increase), bonds often are perceived as "income generating". Psychologically, it feels much less "guilty" for someone to consume their "income" rather than "investment", at least for me.  Think about it, if you bought 10000 shares of Facebook at 20 dollars a couple of days ago, and now it's 21 dollars, you've made 5% gain! But would you sell 500 shares to buy something? Instead, if it were bonds, and the bond somehow magically generated 5% interest in a month, it probably is much easier to transfer the interest to a bank account and use it as your income. Anyway, that's not the only reason they are fascinating :)

So the gains from bonds are actually pretty counter intuitive. This can be demonstrated through a question: Is interest rate increase a good or a bad thing for a bond that you hold? For many people without any investment education, the intuitive answer would be: "of course it's good, because more interest rate means more income per month!" Well, it's not exactly that straight forward, and most of the time, it's the opposite to the straight forward answer.

If you bought a bond from someone with an annual rate of 5%, and later interest rate increases for new bonds purchased from the same person / entity, your bond does not benefit. At all. Most bonds are fixed rate bonds and their interest rates are set when issued. Now what then, does the increase in interest rate mean for the bond your currently hold? It means, its price will drop. In this particular case, a lot, because the 5% hike in interest rate. How does this work?

Let's do the math. Imagine you bought a bond for 10k with 5% interest rate, the bond matures after 10 years (i.e. the principal will be paid off after 10 years). For simplicity's sake, let's assume the principal is paid off at the end of the 10 years. This means that you would have collected 10k * 5% * 10 years + 10k = 15k. This number is the total payment including both principal and interest. Of which, 5k is your return. Now the interest rate has risen to 10%. A different person, interested in these bonds, then has two choices:

  1. buy the bond from the original issuer for 10k, and expect 20k total payment in 20 years (100% return). 
  2. buy the bond from you, with a price such that a return of 100% over 10 years can be secured. Now you'll have to sell your bond at an discount to convince people to buy it from you. In this case, you would have to sell it at 7.5k, which means 100% return in 10 year given your bond's 5% interest rate. 
Through this simple example, you can see how interest rate fluctuations go completely against bonds' prices. And maybe you can also see, that the longer the bond has to wait until maturity, the greater price volatility. But note, that even if a bond's interest rate suddenly surges, usually they still have a much lower volatility than stocks. 5% interest rate change is considered "extreme" for bond, which result in 25% price drop of a 10 year, 5% yield bond, and the price drop is even less pronounced when the original yield is higher. For example, should the original yield in the last example we used be 10%, the price drop would have been 20% instead of 25%. One must also keep in mind that technically, if you give up liquidity, you can still make a profit with that 5% bond you hold in the example, you just need to wait for the entire 10 years, which will enable you to pocket that 50% return.

So this is the so-called interest risk. It's a risk that is present in almost all bonds, regardless of their ratings. Longer-term bonds with lower interest rate are especially tied to this type of risk, whilst short-term bonds are much less sensitive to interest rate changes. So next time when you seek yield, which normally leads you to long-term bonds, make sure that you factor in interest risk.

In the next post, I will touch on the other side of bond risk, the often-mentioned "credit risk". 

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