Risk Management – Interest Rate Risk
Since interest rates have been the topic of much conversation and debate recently, we thought we’d start here. What exactly is interest rate risk?
Let’s say you have a portfolio of securities and you bought the entire portfolio back in 2004 when interest rates were comparatively much higher than they are now. Your intent in 2004 was to subsidize other sources of income during retirement. Or perhaps you were younger at the time and wanted a ‘base’ to your portfolio that would throw off cash streams that could be used to purchase other securities. Essentially planning on reinvesting the interest rather than removing it from the portfolio.
You’ve had some very good news since then in that as rates go lower, the prices of already purchased assets go higher since rates and price are inversely proportional. If you had a fistful of bonds in 2004, there has been a decent amount of capital appreciation. And your yield on those bonds is still the same as it was in 2004 – if the bonds haven’t matured and rolled over into new ones. You’d have had to be in the 20-30 year range on bonds if your 2004 bonds haven’t matured for obvious reasons.
But what about your reinvestment strategy? It’s been put through the meat grinder. Compared to 2004, you’re going to pay more for assets that yield MUCH less. You can avoid paying more by purchasing new issues at or near par, but you can’t avoid the massive destruction of your interest cash streams. If you’re re-investing, maybe you can shuffle a bit and if your time horizon is long enough, this might well pass – rates have nowhere to go but up.
What if you’re using those interest payments to subsidize your fixed income from SocSec during retirement though? You need the yield. Your advisor tells you the only way to get the yield is to buy ‘high yield’ CEFs, ETFs, bonds, private equity funds, etc. What your advisor might not be telling you is that you’re going to be stuck buying securities that are maybe a step or two above a rating of ‘junk’. Your risk just went through the roof to attain the same yield as previously. This happens to many investors and they don’t even realize it because their advisors and brokers are derelict in their ethical responsibilities towards their clients. Fortunately all investment professionals don’t fall into this category.
Asking your current financial professional about risk is a good way to gauge how sincerely they are approaching the stewardship of your assets. Financial professionals are required by law to ask you questions about risk tolerance when they take you on as a client and then periodically after that. A diligent approach is to perform a yearly check up and make sure the client knows to let their financial professional know if there are any major changes in their lives between check-ups. The professional can then determine if re-structuring the mix of assets is necessary.
You should be asking about risk in general regardless of your age or portfolio design and making sure the recommendations you are given are in line with your risk tolerances.
The darker side to investing in low-rated investment grade assets involves what is known as default risk. We’ll take a look at default risk tomorrow.
Sutton/Mehl