Do You Understand Interest Rate Risk?

Are dividends good?  Is interest good?  The truth is that it depends.  Dividends and interest are subject to income tax and associated with investment risk, market risk, default risk and interest rate risk.  From time to time, I meet with a prospective client who simply cannot understand that dividends are not guaranteed and/or an investment with a high yield has more risk than an investment with a lower yield.

Sometimes a person’s addiction to high yields is so strong that they will not believe their own eyes reading their own statement!  Here is an example; A person invested $100,000 in an investment a year ago with a 6% yield.  6% represents a cool $6000!  However after one year, their investment is worth $94,000.  The investor did indeed receive their 6% dividend yield ($6000), but their principle declined by $6000.  The total return is zero percent!  To add insult to injury, the total return, net of taxes, is negative because the $6000 yield is subject to income taxes!

“But I have a regular, steady cash flow” the investor exclaims defiantly!  Uh huh.  You received your own principle back, except it is subject to income taxes.  Brilliant!  You’d likely be shocked how many “Advisors” don’t understand how some investments work.

Information isn’t knowledge and it’s certainly not wisdom.

***I have used information from the Finra.org website in writing this article***

When interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. Interest rate risk is the risk that changes in interest rates may reduce (or increase) the market value of a bond or bond fund you hold. Interest rate risk—also referred to as market risk—increases the longer you hold a bond.

Say you bought a 10-year, $1,000 bond today at a coupon rate of 4 percent, and interest rates rise to 6 percent.

If you need to sell your 4 percent bond prior to maturity you must compete with newer bonds carrying higher coupon rates. These higher coupon rate bonds decrease the appetite for older bonds that pay lower interest. This decreased demand depresses the price of older bonds in the secondary market, which would translate into you receiving a lower price for your bond if you need to sell it. In fact, you may have to sell your bond for less than you paid for it. This is why interest rate risk is also referred to as market risk.

If you have ever loaned money to someone, chances are you gave some thought to the likelihood of being repaid. Some loans are riskier than others. The same is true when you invest in bonds. You are taking a risk that the issuer’s promise to repay principal and pay interest on the agreed upon dates and terms will be upheld.

Generally, bonds are lumped into two broad categories—investment grade and non-investment grade. Non-investment grade bonds are also referred to as high-yield or junk bonds. Junk bonds typically offer a higher yield than investment-grade bonds, but the higher yield comes with increased risk—specifically, the risk that the bond’s issuer may default.

Dividend-paying stocks and stock funds may react very similar to interest rate increases or declines.

Questions to Ask Before Changing Investments

  • Does the higher return from the investment come with increased risk? Invariably the answer is yes. The relationship between risk and return in the investment world is quite robust. The promise of higher return is almost always associated with greater risk and an increased possibility of investment losses.
  • Do you understand how the investment operates?  The quest for higher return could lead you to very complex investments. If you do not fully understand how your investments function, you could find yourself surprised by outcomes you didn’t expect, such as illiquidity, exit fees, loss of principal or the return of your investment in a form other than cash.
  • What are the costs and fees associated with the new investment? Not only is the promise of higher return associated with greater risk, but some of these investments have higher costs as well. For example, hedge funds and structured products can be very costly, and since some of the costs are built into their return, it can be difficult to know what you are truly paying.

High-Yield” Bonds

A common method of chasing return is to move from investment grade bonds to high-yield bonds. However, when investors seek more robust returns in high-yield bonds, they are accepting higher risk in pursuit of higher returns.  When you own high-yield bonds, you are “loaning” money to a bond issuer with a poor credit rating!

High-yield bonds are bonds with lower credit ratings and a higher risk of default. As a result, the bond issuer has to pay a more attractive interest rate to compensate the investor for the additional risk. High-yield bonds can make sense in many portfolios, but remember that the higher yield may come with the increased possibility that you could lose money on your investment.

Investor Tip—Individual Bonds vs. Bond Funds

If you are trying to increase your yield by investing in a bond mutual fund or Exchange Traded Fund (ETF) as opposed to individual bonds, remember that the value of your investment is not only affected by prevailing interest rates, but also by the willingness of investors to remain in the fund.

For example, in a rising equity market, other investors might choose to leave the bond fund and seek higher returns by purchasing equities. As a result, the fund manager could be forced to liquidate bonds at a loss in order to pay out departing investors, which could drive down the value of the fund. So, even though you may have no intention of selling your bond shares, the decision of other investors to sell their positions could impact your overall yield.