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A Simple Way to Measure Bond Risk
04/27/2011 12:54 pm EST
It pays to keep track of the volatility of your bonds or bonds you’re interested in. In this exclusive interview with MoneyShow.com, Christine Benz of Morningstar explains how.
I know a lot of investors are holding bonds. You know after the crash of the stock market in 2008, a lot of people fled equities and went into bonds.
I’m not saying necessarily that they should give up bonds, but what should they do if they’re holding them now?
Well, I think you want to take a look at the interest-rate sensitivity of any bonds or bond funds in your portfolio.
One statistic I would draw people’s attention to is called duration, and this is meant to measure a portfolio’s sensitivity to interest rates, so find the duration for the fund. It should be something that your fund company makes available to you.
Then, you also want to find a figure called SEC yield. You subtract SEC yield from the duration, and when you look at that amount, that’s about how much you could expect the fund to lose in a one-year period if interest rates went up by one percentage point.
So if you’re not comfortable with that level of volatility, you’d want to think about getting into a different investment with a shorter duration and less interest-rate sensitivity.
That formula, by the way, comes courtesy of Ken Volpert at Vanguard. He’s Vanguard’s big fixed-income guru.
Christine, is it better for individuals in this type of environment to hold individual bonds, or a bond fund?
Well, I like the diversification and professional management you get with a bond fund. Especially anytime you move out on the credit-quality spectrum into corporates—or certainly municipal bonds, you don’t want to be tied up with a single municipality given what we’ve seen going on—so I do like that diversification and professional management.
The issue is, in a rising interest-rate environment you may have losses, so you can’t just hold the bond to maturity. It’s different with a bond fund. You’ve got a lot of moving parts, so you may have losses, but I do like that diversification. And it should come out in the wash if your holding period is reasonably long, say five years or so.
When you mentioned the interest-rate risk, what about the inflation risk? Inflation is the bane of bonds.
Absolutely. You know it’s funny, I have thought about inflation on and off over the past few years. Now it’s back on, because we’ve seen a sharp increase in food prices and energy prices recently.
I do think that treasury inflation protected securities (TIPS) are a good portion of investor’s fixed-income portfolios but the fact is TIPS are looking a little bit expensive these days. So, to the extent that you decide you want to add them to your portfolio, I think it makes sense to dollar-cost average into them over a period of six months, or a year, or more.
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