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Bonds Are More Than Yield
There's Risk in Opting for Higher Rate
By Mike Ruff, Portfolio Manager
Russell Investment Group
Global Leaders in Multi-Manager Investing
June 11, 2004
This article has been provided by our parent company, and any references to rates or returns are based in $US and specifically relate to US markets.
At first glance, it seems a no-brainer. Which is the better place to put your money — a bond fund yielding around 8% a year, or one yielding 4%?
Most people, having no other information, obviously would opt for the 8% fund. But, as with many investments, it's not as simple as it appears at first glance.
Bonds are not just about yield, they are about total return. Higher yields usually mean higher risk. So you may be putting more of your capital at risk by buying the higher yielding bond than you are with the more conservative investment.
It's this factor of total return that makes bonds different from less risky money market instruments. If you invest, say $100,000 in a money-market account with a yield of 1% you should receive $1,000 a year and your original $100,000 should stay intact.
But the higher yield that you will receive on a bond comes at a price because the capital is also at risk. The amount of your original investment can go up or down.
Rate changes, defaults and risk
So, although you may receive 8% on your high-yield bond investment, it's also possible that the amount you originally invested may fall to $80,000 or less if interest rates are trending upward and if more risky companies that have issued the bonds default on their loans.
Of course, should interest rates fall and should few companies default your capital may gain. But you can never know in advance in which direction rates will move. Indeed, bonds are traded throughout the day and their yields and prices change minute by minute during trading hours.
This volatility means that one of the few things you can be sure about is that the capital amount you invest in bonds will not remain the same. As a general rule, the higher the yield the greater the volatility you can expect in bond prices. If rates rise sharply, prices on bond funds are likely to fall sharply, too, and there is a chance the higher yielding bonds will fall even more sharply than the lower yielding. So, should you need to draw on the capital for an emergency in such a year, you stand to lose.
Interest rates may rise, but, of course, it's also possible that US interest rates — which have gained on average about 1% in the past couple of months — may fall back once more, causing bond prices to move upward. The risk you take is that you never know for sure which way they will move.
There's return beyond yield
The lesson is clear. Do not look at the yield as your only criterion for investing in bonds. Look at total return. And realize, too, that higher yields usually are accompanied by higher risk.
Copyright(C) Frank Russell Company 2004. All rights reserved. See Important Legal Information and Sales Diclosures. Date of first use: 06/11/2004
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