How to evaluate interest rate risk, credit risk and other factors when investing in bonds.
In this episode you’ll learn:
- What determines interest rates.
- What determines the performance of fixed income investments.
- How to estimate the return of fixed income holdings.
- The tradeoff between owning individual bonds or bond funds/ETFs
Investing in bonds and other fixed-income securities is a complicated topic – one that David unpacks on this episode of Money For the Rest of Us. Throughout this episode, you’ll hear about the factors that influence an economy’s interest rates and how they impact the prices of bonds and other investments. You’ll learn about the contributing factors to a fixed-income security’s performance, as well as poignant questions that’ll help you decide on if you’d like to hold bonds or not. It’s an intriguing episode, and one not to be missed.
Many factors influence interest rates in an economy
Essentially, an economy’s interest rates are “based on investors’ expectations regarding inflation and their expectations of future short-term interest rates.” In addition interest rates are determined by the additional compensation (i.e. the term premium) that investors demand for unexpected inflation or if the central banks raise short-term interest rates more aggressively than expected. David discussed interest rates in depth on episode 191, “Has a Bond Bear Market Begun” – be sure to check it out for even more details.
The prices of bonds and other fixed-income securities fluctuate as interest rates change
As interest rates change, they influence the prices of bonds and other types of fixed-income securities. David explains, “The degree to which a bond price changes as interest rates fluctuate depends on when the bond maturity, its yield, and other features. That price sensitivity to interest rates is known as duration. Duration is essentially the weighted average maturity of a bond or a bond portfolio’s cash flow.” When examining your investment options, it’s important to consider a bond’s yield, its price sensitivity, and its duration. These three components need to balance out in order for your amount of risk to be compensated appropriately. You also need to consider the amount of credit risk involved or the risk of default.
What determines the rate of return performance for fixed-income securities and investments?
There are 3 factors that influence a rate of return on a bond or similar type of investment. The first is the amount of interest income, or yield received. The second is the change in prices of the bond or investment. The third factor is the impact of a default, which David explains as the amount of impact a defaulting bond would have on your portfolio.
How can you decide whether or not to hold bonds?
Taking all of the factors into consideration (the economy’s interest rates, the rate of performance, and the prices of the bonds), it’s easy to see why leveraging these investment strategies can be challenging. David outlines a few major factors he considers when evaluating his portfolio. He asks himself, “How much volatility am I comfortable with? What types of options do I want with my various asset classes? Am I looking for stability or flexibility? And am I willing to make last-minute changes in my portfolio if needed?” By asking yourself these questions, and listening to the full audio for this episode, you’ll be better prepared to begin investing in bonds and other fixed-income securities.
- [0:11] Predicting interest rates can be tough – here are some things to consider
- [4:28] What determines the rate of return if you invest in bonds or fixed income securities?
- [7:00] Bond prices fluctuate as interest rates change
- [15:30] Data on default rates for bonds and other investment strategies
- [19:40] Consider this before deciding whether or not to hold bonds
- [23:13] Passive vs active investment strategies in bonds and other fixed-income securities
- [25:35] Why would you own a long duration bond?
- [34:19] There isn’t a single right answer when it comes to bonds and fixed income securities