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How to Make Your Investment on Bonds Risk-free

By Charlotte

Risk in investments is an everyday problem to both investors and non investors. About three quarters of the people in the world are afraid to invest due to the different levels of risk and uncertainties attached to it while the remaining quarter actually takes the risk inspite of their fears. Whether rich or poor, “Lily livered” or strong minded; people are always looking for a means to lower risk but still make high profit by finding and making low risk high yield investments. Some have described the concept of totally risk-free investments as “The Greater fool” theory which implies that an investor can purchase a bond, stock, real estate or any security without regard for their value; this is done with the notion that there is always someone else out there who will buy it higher from them and thus they will make profit no matter what. Therefore the concept of “risk free” is not as plausible as it may seem as many who go into investments with such ideas end up purchasing junk or worthless securities and end up at a loss but in as much as it is not totally risk free; low risk investment options exist; some lower than others. Bonds are one of such low risk investments.

Bonds are widely viewed as low-risk investments that can fortify overall portfolios against the higher ups and downs of stocks. Like any asset class, bonds have distinct advantages and disadvantages. Nowadays, the disadvantages are increasing, as interest rates are getting higher. This climb in interest rates and the fact that, after historically long years of low interest rates, they have nowhere to go but up and this suggests that further increases are not an impossible future outcome. The rise in interest rates punishes existing bonds holders; so many investors are understandably skittish about bonds these days. An Example of low risk bonds are Government bonds which are also known as “Risk free” bonds such as Treasury Bonds (T Bonds) and Inflation bonds ( I Bonds).

These Government Bonds offer many benefits:

–They’re risk-free and safe. Meaning they are backed by the U.S. Treasury and US Government.

–They’re tax-deferred. Even though bonds such as I Bonds are purchased with after-tax money for your taxable account, they offer tax deferral for up to 30 years. One may choose to report the interest annually, but most investors choose the default tax deferral option and thus only pay tax on the accumulated interest when they eventually redeem the Bonds.

–They’re flexible and have ease of liquidation. They can be redeemed anytime between one and 30 years. That offers lots of flexibility. Just like stocks and corporate bonds, government bonds can be bought and sold. For example, if for another period of five years the bond won't mature but physical cash is needed at the time; the bond can be sold to another investor and get your money out. However, because of the fluctuating nature of market conditions, you could find yourself taking a loss to when selling the bond. On the other hand, a gain could be made depending on circumstances.

–They’re free from state and local taxation. Unlike an IRA or 401k, there are no state or local taxes on the interest that you earn when you cash-in a savings bond.

-They have Fixed Rates. Having a fixed rate on government bond allows for budgeting on how much income will be spent on receiving payments. Moreover, if interest rates fall, your rate is unchanging so you earn a higher rate than the market is paying. There is always the chance that the interest rates could increase and in such circumstances, having a fixed rate hurts you because you will end up with lower rates.

 Considerations to be Made when Choosing Investment Options 

Inorder to acquire low risk bonds, the following must be considered:

  1. 1.     Interest rate risk

Bonds with high interest rate risk tend to perform well when rates are down, but they will not perform well when interest rates are rising. It is an important fact to consider that bond prices and yields move inversely, that is in opposite directions. Due to this, rate-sensitive bonds will most likely perform best when the economy is going down, since slower growth tends to lead to falling rates.

As the interest rates of new bonds reflect the economy's existing rates, new bonds issued at such periods pay higher rates than those issued when at lower rates. So, if you own a bond that pays 5 percent when new bonds are being sold at 7 percent, this means you would be operating at a loss should you choose to sell. If you choose to hold on to a bond of good credit quality until maturity, there is a probability you’ll get your money back plus the interest. But if the bond has a long period before maturity say, 25-30 years and prevailing interest rates go up satisfactorily, you could lose because of inflation. Inflation tends to rise with interest rates. If you have a 10-year, $1,000 bond that pays 5 percent annually. Every year, you'll receive $50 in interest, and at the end of the 10 years, you'll get your $1,000 back. In a similar manner to other bonds, corporate bonds tend to rise in value when interest rates drop, and they fall in value when interest rates are up. The longer the maturity of your bonds the greater the degree of price volatility. Therefore if one holds a bond until maturity, the bond holder may be less concerned about these price fluctuations, because you will receive the value of your bond at maturity.

Some investors are confused by the inverse relationship between bonds and interest rates, that is, the fact that the value of bonds reduce or are worthless when interest rates rise. There exist straightforward explanations for it:

When interest rates rise, new issues come to market with higher yields than older issues, making those older ones worth less than they originally were. Hence, their prices go down. When interest rates drops, new bond securities come to market with lower yields than older securities, making those older securities higher-yielding and worth more. Hence, their prices go up. As a result, selling ones bonds before maturity may make the bonds worth more or less than you paid for it originally. There exist various economic forces that affect the level and direction of interest rates in the economy.  When the economy is growing, interest rates typically climbs and vice versa. Similarly, a rise in inflation leads to a rise in interest rate (At some point, higher rates may contribute to higher inflation), and moderating inflation leads to a decrease in interest rates. Note that Inflation is one of the most influential forces on interest rates.

  1. 2.     Longevity risk

For individuals, longevity risk would apply to the risk of a person outliving their assets, resulting in a lower standard of living, reduced care, or need for employment. For institutions providing covered individuals with guaranteed retirement income, longevity risk applies to the risk of underestimating survival rates (mortality rates of a person) thus resulting in increased liabilities to sufficiently cover debts. Institutions facing this risk include defined benefit pension plan providers, (re)insurance companies, and certain financial institutions.

An increase in the life expectancy of pension fund or annuity beneficiaries can therefore result in pay-out levels that are higher than originally anticipated and accounted for by companies and their pension fund administrators. The fundamental problem for pension funds and life assurance companies has been the unpredictability of medical advances and their effect on life expectancy in general. The adverse effects to longevity from factors ranging from alcohol consumption to obesity are equally difficult to predict and it is not clear whether there is a natural limit to life expectancy making it difficult to rely on historical data when determining the future life expectancy of pension plan or policy holders.

In order to manage this risk, bond investors should avoid having too much money in long-term bonds (that is, limit the years of maturity to your bonds). While U.S. Treasury bonds have the best credit quality, people who over-invest in long-term Treasuries during retirement set themselves up for severe losses in buying power and increase the risk that they will outlive their money. Various ways in managing longevity risk include:

Diversify the risk. The longevity risk exposure can be diversified across investment options, geographic regions or socio-economic groups. But, most market participants tend to be exposed to longevity risk in the same way, which makes it difficult to diversify this risk across different life insurance portfolios or pension schemes.

Maximize natural hedges. A portfolio can be balanced by trying to maximize natural hedges.

Take care of pension liabilities. Corporate pension funds, in theory, can pay to have their pension liabilities assumed by another corporate pension fund. However, companies that would simply like to close their pension fund schemes are legally obliged to buy them out in full which often renders it too expensive. It is considered virtually impossible to buy insurance covering longevity risk.

Share the risk with Annuity beneficiaries. Annuity providers may decide to pass on the exposure to longevity risk in part to policy holders. Rather than calculate the mortality rates at the beginning of the contract period, providers can link the pay-out to actual mortality rates. But note that this would make the product less transparent at the outset and as such, less attractive.

Securitize Assets and liabilities. The company might securitize the assets and liabilities that are exposed to longevity risk and thereby pass on the risk exposure to investors.

Share the risk with capital market participants. The company can decide to manage the risk through securities such as mortality and longevity bonds, or other mortality-linked financial instruments.

3.     Credit risk (or default)

Individual bonds with high credit risk do well when their underlying financial strength is improving, but weaken when their financial strength deteriorates. Entire asset classes can also have high credit risk; these tend to do well when the economy is strengthening and underperform when it is slowing.

A Government bond in a country's own currency is strictly speaking a "risk-free" bond. This is so because the government can if necessary create additional currency in order to redeem the bond at maturity. Credit quality is critical. When it comes to stocks, most people recognize the risk that their value will go down but they are unaware that bonds also hold that same risk. It is a good idea to avoid junk and instead invest in investment-grade corporate bonds, and U.S. agency bonds, whereby even though they pay low rates, they have the lowest credit risk of any bond.

  1. 4.     Currency risk (Foreign Currency risk)

Currency risk refers to the risk that the value of the currency a bond pays out will decline compared to the holder's reference currency. That is buying bonds across different countries with different currencies and exchange rates may result in an increase or decrease in the value of the bond. That is a United States investor would consider German bonds to have more currency risk than United States bonds (since the euro may go down relative to the dollar) and vice versa. Equally, a bond paying in a currency that does not have a history of keeping its value may not be a good deal even if a high interest rate is offered. These are four ways by which foreign currency risk can be managed:

Invest in countries with strong, rising currencies. High debt usually precedes high inflation. When inflation kicks in, currencies usually fall as confidence in them falls. However, countries with a low debt to GDP have rising currencies, which can be profitable for investors.

Foreign Bonds are very susceptible to Currency fluctuations. Bonds are especially vulnerable to currency variations, since they have lower profit to offset currency losses. When investing in a foreign bond index, currency fluctuations can be more or less 10 percent; these changes are double what a bond may return. Currency fluctuations have a much greater impact on foreign bonds than changes in the bonds’ prices. Historically, most foreign-country bonds were issued in dollar valuations. Today, many are issued in local currencies. Investors can still find bonds issued in dollars, and this is more stable investment.

Invest in currency-hedged funds. The best way to protect your foreign returns is to invest in mutual funds or exchange-traded funds that are hedged. These funds usually use sophisticated investments like futures and options to hedge the currency risk of an equity or bond, and thus reduce losses.

Diversify bond investments globally. If you have lots of investments in foreign securities, be sure to have investments in a basket of regions, rather than in just one region. Diversify across different geographic regions.Another option is to invest in regions where the currency is attached to the dollar. For example, in Middle East countries, such as Lebanon and Saudi Arabia; their pounds and riyals are pegged to the dollar. Alternatively, several African countries, like Senegal and Cameroon peg their currencies to Euros. Generally, it can be said that currency volatility is at an all-time low for developed countries, despite rising geopolitical risks, the dollar is still the world’s safe-haven currency. Therefore, if there happens to be trouble overseas, the dollar will appreciate.Lastly, don’t put all your assets in foreign markets. At most 25 percent of portfolio assets should be involved in the foreign market. It is very important for investors to understand the currency risk involved in the foreign market.

  1. 5.     Inflation risk

Inflation risk refers to the risk that the value of the currency a bond pays out will decline over time. It is normal for investors to expect some amount of inflation; therefore the risk is that the inflation rate will be higher than they expect. Many governments issue inflation-indexed bonds. These bonds protect investors against inflation risk by linking both interest payments and maturity payments to consumer prices index. Although related to interest rates, inflation risk is slightly different. For example, if inflation run at 7 percent, consistent with the rise in interest rates during a period, one will have less buying power and be unable to sustain the same cost of living that you had 10 years ago when you purchased the bond. As such, your standard of living can be cut because your return on the bond didn't keep up with inflation. Interest rate risk is inherent in bond funds, where investors buy shares in collective investments (like mutual funds) that own many bonds. Owning a government agency bond, that is backed by the full faith of the government, or by an investment-grade corporate bond, makes it possible to hold it until maturity and thus get all the interest, plus your initial investment.

If the duration isn't too long and you bought wisely (mindful of the economic forecasts at that period), you probably won't suffer much from inflation risk because inflation will be offset by the interest you collect at maturity. However, with mutual fund bonds, which can hold dozens or even hundreds of bonds, it is not possible to get to this point because fund managers sell their funds' bonds before maturity to create liquidity for investors redeeming shares and to justify their existence as active managers. Thus bond funds are valued at the end of each day, and reflect the value of the underlying instruments they hold as such you can't wait until maturity to collect your full investment. Moreover, bond funds have a tendency to be volatile. For these reasons, bond funds are not recommended no matter what interest rates are doing.

Achieving Low Risk High Yield Investments (Bond Investments)

Reducing Risk in Investment Bonds

In order to obtain low risk investments for Bonds, the following should be taken into consideration;

Generally, the market value of the bonds owned will decline if interest rates rise. As such this suggests several risk-reducing steps you can take as a bond investor, which are;

-Purchase Bonds at Stable Interest rates

Bonds should not be bought when interest rates are rising. Cash should be put in a money-market fund or in certificates of deposit which may mature in three to nine months. The best time to buy bonds is when interest rates have stabilized at a relatively high level or when they seem about to head down. This is a very important step to ensure the purchase of low risk bonds.

-Stick to Short and Intermediate-term Investment Bonds

Sticking to short- and intermediate-term issues is another way to go in achieving low risk investments. Bonds with maturities of three to five years reduce the potential volatility of your bond holdings. This type of bonds fluctuate less in price than longer-term securities, and they do not require you to tie up your money for ten or more years in exchange for a relatively small additional yield.

-Diversify Bond holdings

To possess low risk bonds, bonds with different maturity dates should be acquired as such there is diversification of your bond holdings. Mixing securities that will mature in one, three, and five years will protect you from getting hurt by uncontrollable interest rate movements. Mutual funds are an excellent way to achieve diversity in your bond investments. Concerning Junk bonds, you could purchase shares in a junk bond mutual fund, this would ease the risk a bit through diversification. Even then, junk bonds should occupy a very small portion of your portfolio.

-Check the rating of any bond that you are considering purchasing or already own. Information such as the rating can be given to you by a broker or you can check online sources, such as Bondsonline.com. In the case of a mutual fund, the prospectus will show the lowest rating acceptable to the managers; the annual reports should list the bonds in the fund's portfolio, along with the bonds’ ratings. Generally, the lower the rating, the greater the yield a bond must offer to compensate for the risk.

Reducing Risk in High-Yield Bonds

Techniques in achieving low risk High yield investment bonds include:

-Diversification across issuers and industry segments. Avoid putting all your assets in one high-yield bond. Money spread among several issuers and industries can help reduce the risk of price declines or defaults caused by industry-specific situations/circumstances. Thus attaining low risk high yield investments.

- Understand the different economic and market periods. One of the best times to own high-yield bonds is during the expansion phase of an economic cycle, that is, when financial measures are increasing along with consumer confidence. The worst time to obtain high yield bonds is at recession periods, which is, when financial measures deteriorate and investors become increasingly anxious about holding higher risk securities.

-Rating agencies should be monitored. Follow the publications of the rating agencies, as this may indicate advance warnings of difficulties of the market. Before downgrading the rating of an issuer, these agencies often place the company on a “credit-watch” list.

-Equally monitor company and industry news. Follow an industry or an issuer closely; just as you would follow equities. This helps to anticipate factors that may impact the credit rating or the price of a bond.  

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