A Simple Way to Measure Bond Risk

04/27/2011 12:54 pm EST

Focus: BONDS

Christine Benz

Director of Personal Finance, Morningstar, Inc.

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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