Fixed Income: Risk vs. Return

In the race to achieve higher investment returns, fixed income is often the tortoise while equities are the hare. So why include bonds in your portfolio? The main reason is diversification. Within a diversified portfolio, bonds can reduce volatility, particularly when stock markets decline.

Although fixed income products have proven to be less volatile than equities over time, there are still very real risks to investing in fixed income. Bond prices can go down, and issuers can default. We discuss the main risks of fixed income investments here.

Interest Rate Risk

Fluctuations in interest rates can prove challenging for bonds. Bond prices tend to have an inverse relationship with interest rates - when interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. Interest rate risk generally refers to the risk of rising interest rates and a reduction in the market value of a bond. Securities with a longer maturity date and a lower coupon (interest) rate will be more sensitive to changes in market interest rates.

Some good news is that while existing bond prices may decline, reinvesting coupon income at higher interest rates could work in your favour over the long term. Rising interest rates can also can make new bonds more attractive because they are offered at a higher coupon rate.

Duration Risk

Duration measures a bond's sensitivity (or how much a bond is likely to fluctuate in price) to a one percent change in interest rates in either direction. Duration risk, therefore, specifically relates to how much a bond's price can be expected to fall as per a 1% increase in interest rates. While duration is stated as a measure of time (years) it is an important factor in the world of fixed income, as it is often used to compare a bond to a benchmark or similar bonds when assessing risk. Generally, the higher the duration number, the more sensitive a bond investment is to a change in interest rates.

Default or Credit Risk

The risk is that a bond issuer becomes insolvent or unable to service its debt obligations (make coupon payments or repay the principal of the bond) in a timely manner. This can lead to a partial or total loss of an investment. Generally, bonds with a lower credit rating by rating agencies such as Standard & Poors and Moody's have a higher potential for default. For example, credit risk is more often associated with high-yield bonds as these bonds have lower credit ratings and correspondingly higher risk.

Credit risk, however, also applies to investment grade bonds as rating agencies are continually evaluating the creditworthiness of fixed income issuers and the ratings they assign are subject to revision at any time. A rating agency may issue warnings or place an issuer under credit watch which usually leads to a decline in a bond's market value and/or a future downgrade in a bond's rating.  

Diversification of fixed income products by issuer type (government and corporate), and by issuer (different levels of Canadian government, international governments, companies operating in different sectors) can help to minimize credit risk. To learn more, see Fixed Income Types.

Inflation Risk

The risk is that the yield on a bond will not keep pace with purchasing power, resulting in lower return expectations. This happens because inflation erodes the purchasing power of cash flows as the coupon payments and principal received from most fixed income products are not adjusted to account for inflation. This means that if inflation is high, you will be able to buy less with the money you receive. Real return bonds, which are issued by the Government of Canada, and some provinces, can be a solution as their cash flows are indexed (adjusted) to inflation.

Reinvestment Risk

If you are investing to accumulate wealth (that is, planning to reinvest interest payments received) rather than generate current income, then reinvestment risk becomes an important factor. Future coupons must be reinvested at the prevailing market rate, so changes in this reinvestment rate will positively or negatively affect the compounded yield to maturity of your investments. Also, some bonds carry a “call” feature, which allows the issuer to redeem the bond prior to maturity after a certain date if conditions are met. In this case reinvestment risk is higher because you may have to reinvest the principal earlier than anticipated.

Liquidity Risk

Fixed income is often, but not always, quite liquid. This means that sellers are generally able to find buyers willing to buy bonds at or near the market price. Liquidity, however, is usually not guaranteed. This means that in some instances fixed income holders may have difficulty finding buyers, or might have to sell at a significant discount. Some securities, like most guaranteed investment certificates (GICs), cannot be resold.