Risks in Fixed Income

Terry Flanagan

While investment in any asset class will carry with it inherent risk, there are some that are unique to the fixed income space.

Market volatility, trading volume and macroeconomic news are each factors that can affect the amount of risk in an investment, and while these also apply to fixed income, it is the unique relationship that bonds have with interest rates that perhaps most directly affects fixed income.

“Investing and trading in fixed income securities carries many risks,” said David Killian, senior vice president and senior portfolio manager at Valley Forge Asset Management, a subsidiary of Susquehanna Bancshares. “Primarily interest rate and credit risk. Given the historically low level of rates, at this juncture, mark-to-market risk in fixed income would be the more significant of the two. While credit risk is always present, for investment grade bonds historic default rates are close to 0%.”

As interest rates rise, the existing bonds that had already been issued would decrease in value, since investors would clearly opt for the newly issued bonds with higher yield. The inverse occurs when interest rates drop.

“If you have rates that over time increase from where we are now, the asset value will go down,” said Peter Campfield, president of BondDesk Trading.

The biggest risk going forward with fixed income will be interest rates rising. As current rates are pretty much at rock bottom, there is little room to go except up. When the inevitable rise in interest rates occurs, existing bonds will drop in value.

Despite this, fixed income is inherently a safer investment than equities and other asset classes. During uncertain macroeconomic times, liquidity in U.S. Treasurys soar as investors seek the safety of U.S. debt.

In the third quarter of 2011, when the Chicago Board Options Exchange Volatility Index hit a high of 48, nearly $1.1 trillion in bonds were traded daily on average, which was the highest since the fourth quarter of 2010, according to Credit Suisse data. This is in contrast to the first half of the year, when about $1 trillion in bonds were traded daily.

During the first three months of 2012, bond trading increased about 7% over the fourth quarter of 2011, but was actually down about 1% from the first quarter of 2011.

Corporate debt in particular has been on a steady growth path over the past decade. In 2002, there was about $4 trillion in U.S. corporate debt outstanding. As of the end of 2011, that number was approaching $8 trillion.

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