When Bonds aren’t Necessarily Safe

By on March 28, 2010

Tom Lauricella, writing for The Wall Street Journal, has written an enlightening and timely article entitled, “The Risks of Rising Interest Rates.” Lauricella covers the basics and more:

The first stop for any bond investor is a statistic called “duration.” It boils down to a simple rule: The longer the duration, the more sensitive a bond or bond fund is to changes in rates. A U.S. Treasury 10-year note, for example, has a duration of seven years, which means its price will likely fall by 7% should interest rates rise one percentage point.

But there are nuances to duration. Chief among them is that when comparing different types of bonds, such as Treasurys and investment-grade corporate bonds, the same level of duration doesn’t mean the two will respond identically to rate changes. In the case of corporate bonds, it’s in part because prices also are influenced by the credit quality of the company.

Lauricella explores historical relationships between various bond and bond-like asset classes and their sensitivity to changes in interest rates:

High-yield bonds, known as junk bonds, can be the exception to the rule [of rising rates]. That’s because junk-bond prices tend to be more closely linked to the fate of the corporate issuer and the stock market than to changes in interest rates.

“Generally, high-yield bonds have fared reasonably well when interest rates rise,” says Curtis Arledge, chief investment officer of active fixed income at investment firm BlackRock. The reason: A stronger economy, while leading to higher rates, “also increases the chances that an issuer won’t default,” he says.

A popular destination for yield-hungry investors has been preferred securities. The iShares S&P U.S. Preferred Stock Index Fund, yielding 6.6%, has attracted $1.5 billion from investors since the start of 2009, according to Morningstar.

Many investors don’t realize that preferreds are a hybrid of stocks and bonds. In fact, they respond to rate changes more like long-term bonds than stocks.

The iShares fund doesn’t publish a duration reading and the fund has only been around since 2007. But a look at how the index it tracks performed in 2004 shows the impact of the looming Fed rate increase. Between late January and mid-May of that year, the S&P preferred index was down more than 12%.

Lauricella concludes with a discussion of closed-end funds and those that use leverage to enhance returns leading to an increased sensitivity to changes in interest rates.

Source: The Wall Street Journal

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