INSIGHTS

ASSESSING BOND PORTFOLIO RISK

Cam Watson , 12 February 2016

Some bond portfolios are riskier than others. Risk needs to be managed not only at a portfolio level between income and growth assets, but within each asset class. Some bond portfolios can be higher risk than others. Here are key elements to consider when measuring the risk of a bond portfolio:


Risk:

Interest Rates Decline

How this risk can impact a portfolio

If interest rates fall, a fixed income portfolio that is invested only in short term securities will see its income decline.

How to identify this risk in a portfolio

Look at the average maturity across the fixed income portfolio. If it is unduly short consider adding some longer dated bonds to lengthen the overall average maturity. The laddering of maturity dates remains an effective way of managing interest rate risk. If interest rates do fall then income is locked in.


Risk:

Interest rates rise

How this risk can impact a portfolio

If interest rates rise, the value (or price) of a bond will decline. The extent of any price decline will depend on the bond’s term to maturity. A bond portfolio that is only invested in long term bonds will also have an opportunity cost at not being able to reinvest capital at the higher rates now available.

How to identify this risk in a portfolio

An approximate rule of thumb to calculate how sensitive a bond’s price is to changes in interest rates is to multiply its years to maturity by the rise in interest rates. For example, if interest rates rose by 0.25%, the price of a 4-year bond may fall by 1.0%.

The prices of longer-term bonds are more sensitive to changes in interest rates. However, we note prices revert to issue price at maturity and any loss in market value from higher yields during the period held would only be crystallised on a sell.

Understand your bond portfolio’s average term to maturity and by how much its value could decline if interest rates rise. Ensure you are comfortable with this. The best way to balance this risk against the risk of falls in interest rates is to maintain a prudently laddered portfolio that has a range of bonds with differing maturity dates.


Risk:

Credit risk

How this risk can impact a portfolio

Credit risk, or the risk that an issuer defaults on their interest or capital is an important risk to consider as any loss of income and/or capital can have a material impact on a fixed income portfolio.

How to identify this risk in a portfolio

Identify credit risk in a portfolio by assessing the credit rating of the individual bonds, and the overall average credit rating of the portfolio, acknowledging the bonds with higher credit ratings have lower credit risk. The Craigs Investment Committee supplement credit ratings with our own risk classification of fixed income securities we research.

Assess how well diversified the bond portfolio is across different issuers and sectors/industries. Diversification is an effective way of mitigating credit risk.

Look at the terms of the bonds held. Conventional bonds with set maturity dates and terms, fixed coupon payments and no subordination are lower risk than bonds with less conventional terms and conditions.