There are two basic ways to increase yield. One is to
buy the paper of a lower quality borrower than the U.S.
government. The other is to choose paper that matures
further in the future. Each of these strategies entails
risks that must be managed.
Lower quality
Buying paper of lower quality issuers involves more
risk for the investor because these borrowers, by
definition, are more likely than the U.S. government to
have a problem paying principal and interest. The
probability of non-payment is typically referred to as
“default risk” or “credit risk.” This risk can be
minimized by purchasing investment grade instruments, as
defined by the major rating agencies such as S&P and
Moody’s.
Longer maturities
Buying paper that matures further in the future
usually (though not always) results in higher yields.
This strategy, however, can expose the investor to
significant drops in value even if the borrower is high
quality. This is because a general rise in interest
rates will cause longer maturity paper to drop in price
more rapidly than short-term paper, overwhelming the
positive effects of a higher yield. The following chart
illustrates this tradeoff, assuming a one percent
general rise in interest rates.
| If you
choose this maturity U.S. government bond |
2 yrs |
5 yrs |
10 yrs |
|
Your current yield is approximately (1Jul03) |
1.31% |
2.44% |
3.55% |
| If
interest rates rise by 1%, then ... |
| |
Your yield will
be this much higher than the 6-mo T-bill ... |
0.36% |
1.49% |
2.60% |
| |
But the bond price will
drop this much more than the T-bill* ... |
-1.96% |
-4.03% |
-7.7% |
| |
So you will be
worse off than the T-bill by ... |
1.60% |
-2.54% |
-5.10% |
| |
| *
Rough estimate using modified Macaulay duration.
For illustrative purposes only. |
The tendency of bonds to drop in price when interest
rates rise is commonly known as “interest rate risk.”
Professional bond portfolio managers typically manage
this risk by using “bond duration” and other
quantitative approaches to measure and limit the
sensitivity of the portfolio to changes in interest
rates.
Such a drop in price can be disquieting but largely
academic for investors intending to hold the paper,
since they eventually will receive the face value of a
bond (assuming the issuer remains creditworthy) at
maturity.
Sumner Gerard, CFA
July 2003
|
