How Much Risk Should You Take with Bonds?

Mark Riepe: Welcome to Financial Decoder, an original podcast from Charles Schwab. I’m your host, Mark Riepe.

On this podcast we break down the cognitive and emotional biases that influence your financial decisions and offer strategies to help mitigate those biases and help improve your financial outcomes.

Believe it or not, there was actually a time in America when it was fairly common to see someone standing on the side of the road with their thumb out. Hitchhiking was an everyday way for people, often teenagers, to get from one town to the next. In fact, my dad would hitchhike from his parents’ farm to his college and back, 90 miles each way. Today, virtually no one hitchhikes and, unless you drive for a ride-sharing service or a taxi, even fewer people would pull over to pick up a complete stranger. Why is that?

There are a lot of reasons why hitchhiking declined over the years, but several highly publicized incidents of kidnapping and murder greatly increased the perceived danger of the practice.

I mention hitchhiking because it’s a great example of how perceptions of risk are a powerful factor when it comes to our decision making. What’s interesting is that our perceptions of those risks are often influenced by our individual experiences or the stories we hear from others—especially when they feature details that are so vivid, or salient, that they take on outsized influence. And this tendency to focus on the most prominent information can disproportionately impact our investing decisions as well.

It helps to think of salience as how dramatic an event or a trait is. The more dramatic or noticeable a trait, the more salience it has.

Some behavioral economists have built entire theories using salience as a way of explaining how financial markets move.

Their idea is that when investors can easily imagine a story about a stock that paints a bright future for the company, then they overbid for the shares of that company and drive its price too high. Similarly, when investors can easily imagine a dire future for the company, they get fixated on the possibility of the company failing, and because that potential failure is so vivid in their minds, they overestimate the likelihood of it happening.

One study that caught my eye showed how individuals in Finland¹ who were personally affected or whose friends and families were especially affected by a severe depression in Finland in the early 1990s were less likely to participate in investing years later. Similar results have been found for Americans who lived through the Great Depression of the 1930s.²

Interestingly these biases are truly universal and stretch across both time and geography. To bolster that point, now I’m going to take you even further back to Amsterdam in 1772. Back then Amsterdam was one of the world's major financial centers. In fact, the world’s first stock exchange was founded there in 1602.

But let’s look at a different part of the Amsterdam financial scene, the lending market—a market that had been rocked by the bankruptcy of the East India Company. In particular, speculators had borrowed a lot of money from a group of Dutch financiers, and those loans were backed by East India Company shares.³

This event is intriguing because it illustrates how personal experiences can shape decision making for years afterward.

In this case, when the dust settled after the bankruptcy, none of the lenders lost any money. The reason for that is because the East India Company shares didn’t drop all the way to zero and the lenders had charged sufficient collateral to offset the losses. Even though they didn’t lose any money, the memory of that incident affected them for years.

Before the bankruptcy, this group of lenders offered terms to borrowers that were essentially the same as those required by financiers who weren’t exposed to the East India Company. That all changed with the bankruptcy, after which the exposed lenders tended to require much higher rates of collateral than those who weren’t exposed to the East India Company. It’s as if they were so scarred by the experience, even though they didn’t lose money, that they weren’t going to let it happen again.

In this episode, we’re going to explore how much risk investors should take with bonds. Right now there are many individuals who have been equity-oriented investors for most of their lives. As they get closer to retirement, they realize, correctly, that there comes a time when taking on less risk makes sense.

Depending on your goals, bonds can be an important part of a diversified portfolio. Bonds can help you generate retirement income, help preserve your capital over the long term, and potentially hedge against losses from other assets like stocks.

But like any investment, bonds do come with their own set of risks. How can you best evaluate these different risks? The most important thing is to make sure you’re thinking objectively about the actual risks involved with bonds and not having your decisions clouded by salient stories or experiences that may have been real, but aren’t representative of the risks that exist today.

Mark: Joining me now is Schwab’s chief fixed income strategist, Kathy Jones. Welcome, Kathy.

Kathy: Hi, Mark. Thanks for having me.

Mark: As many more investors move closer towards retirement these days, they may be looking at investing in bonds for the first time because bonds are supposed to lower the risk in portfolios, but like all investments, there are risks associated with them. So, for bonds, what’s the most important risk that an investor needs to think about?

Kathy: I would rate credit risk the highest, and that’s the risk that the issuer of the bond defaults, doesn’t make an interest payment or defaults on the principal, isn’t able to pay off the bond. And the reason that I think that’s the number one risk is because an investor could actually lose money. Other types of bond risks are usually associated with the price declining in the secondary market or an opportunity cost, where you may be tying up your money for a period of time when interest rates go up and you don’t have the opportunity to capture that higher income. But if you hold individual bonds to maturity, you’ll eventually get your principal and interest back if there’s no default. It’s a default that leads to an actual loss that usually can’t be recovered. So that … I think that’s something investors really need to keep in mind when they’re investing in bonds.

Mark: So when you’re buying a bond, essentially it’s a loan, and you want to get repaid, right?

Kathy: Absolutely, yep.

Mark: So if you’re making a loan, it makes sense that you want to assess the credit quality of the borrower. So how is an investor supposed to gauge the level of risk in their bond portfolio?

Kathy: Well, I think a good place to start is with a credit rating. So there are rating agencies—Moody’s, Standard & Poor’s, Fitch, those are the three big ones. They assign ratings to bonds based on their assessment of what the risk of default is. The highest rating is AAA, which means the risk of default is extremely low. At the lower end of the scale are bonds with C ratings, where the default risk is much higher. And then if you get a D rating that means the bond is already in default, that the issuer has missed an interest payment or is not able to pay back the principal.

Mark: So it’s nice that these ratings are available, but are they effective, in the sense that do they actually indicate a probability of default that is useful?

Kathy: You know, they’re actually pretty good. Moody’s did a study going back to 1970, and what they found is that 91% of the bonds that they rated that ended up defaulting had speculative grade ratings at the time of default⁴, meaning they were actually in that range where if you looked at them you would have said, "Oh, this is a really risky bond. It could default." So five years before defaulting they had ratings that were near the bottom rung of investment grade, on average, meaning a little bit higher. So, in other words, the likelihood of the issuer missing that interest or principal payment increases when the issuer gets downgraded.

Having said that, you know, ratings are just opinions. They don’t provide a guarantee of safety. It’s the rating agency’s opinion of the underlying credit quality in the bond. And, also, ratings can change. As I mentioned earlier, the rating agencies monitor the issuer and they may change their assessment. So investors, you know, in addition to looking at the rating, have to watch, as the rating may change over time.

Mark: So not all bonds get ratings, so should individual investors—should they just ignore non-rated bonds, or just avoid them entirely?

Kathy: I would say that if you are looking at unrated bonds you would really need to do some of your own research to assess the probability of default. And, you know, perhaps it’s a bond issued by your community that’s funding a local project like a sports facility, and you might be on a committee that is looking into this for your community, and you might have some insight into how well the project is going to go. So that might be a case where you do buy an unrated bond because you have some insight.

But, otherwise, you know, I would say you’re going to have to find publicly available information, make an assessment, look at the budget, the offering documents. So, in general, if you don’t want to spend your time doing that, you’re probably better off just avoiding unrated bonds.

Mark: So let’s imagine how an investor would actually use this information in practice. I go to a website, I sort the bonds by credit quality, and then I sort them by yield, and pick the one with the highest yield. So, is that a good reason to buy it? Is that a good approach?

Kathy: In general the rule of thumb, like all investing, is that if looks too good to be true, it probably is. By that, I mean if you find a bond with an exceptionally high yield relative to other bonds with the same characteristics, the same credit rating, the same maturity, the same type, there’s probably a reason for it and you should investigate. Often times the issuer of the bond has to get a higher yield because there’s some risk involved with that particular bond.

Mark: So like pretty much every investment, there’s really no free lunches.

Kathy: No, not in the bond market, just like other types of investing.

Mark: So there’s probably no one right answer for every one of the listeners as to the right amount of credit risk that they should be taking in their portfolio. So can you provide sort of a framework that an investor should take to help them determine for themselves what the right amount of credit risk is for them to take?

Kathy: So for most investors, the bond portion of the portfolio is there to generate income, to provide some diversification from the stocks that they hold, and to preserve capital. So, consequently, you know, it usually makes sense for bond investors to keep their holdings in higher-credit-quality bonds. That usually means Treasuries or bonds with investment-grade ratings, and those are from AAA to BBB-, if you’re looking at the ratings.

Now, if your goals are different and, you know, you’re investing aggressively for income, then you might have an allocation to some of the riskier parts of the market. That would be like high-yield bonds. We also call them junk bonds because they’re below the investment-grade rating. It could include leverage bank loans or emerging-market bonds. But unless you have expertise in analyzing these types of bonds, then you’ll probably want to choose a bond fund or some sort of manager so you get diversification, you’re not too exposed to any single bond that might default, or you have professional management overseeing it, because, you know, there’s a lot that can change and go wrong in those more speculative bonds.

There’s also the issue with diversification. So if you’re looking at bonds for diversification from your stocks, you really want to stick with the higher-credit-quality bonds because they actually will move in the opposite direction of stocks, generally speaking, when markets are turbulent. But if you’re in the riskier segments of the bond market, they will tend be correlated with the stock market, so your whole portfolio will move together, and that’s usually not what you’re trying to accomplish when you buy bonds.

Mark: Kathy, you mentioned bond funds, and by that I assume you meant, you know, mutual funds that invest in bonds or exchange-traded funds—we’ve got an episode on that—exchange-traded funds that invest in bonds, is that right?

Kathy: Yeah, that’s what I mean. And some people prefer that, particularly when they’re going into the riskier segments of the bond market, because you get professional management, and you get a lot more diversification for every dollar you invest. Of course, that comes with a fee, but it usually is to people’s advantage to look at something like that versus trying to pick speculative-type bonds on their own.

Mark: So we talked in the introduction about how investors tend to pay attention to the risks that are most salient to them. My guess is that if investors have had past experience with a credit event or a default, then that’s something they’re very aware of, and perhaps too worried about that going forward. Whereas bond investors who have never personally experienced a default, maybe they’re not paying enough attention to that particular risk. Does that resonate with you when you’re talking with individual investors?

Kathy: Oh, yes, absolutely. You know, as much as we might want to forget the investments that don’t go well, I think we tend to carry those memories around with us pretty closely. And I do find that investors who have experienced a default in their bonds, since they’re not typical, they tend to be very skittish about taking any kind of risk. An example that really comes to mind is the Lehman Brothers. They were A-rated when they defaulted. So that just came out of the blue for a lot of people. And obviously this is a fairly unique situation, but I find that there are investors who actually will avoid banks and financial institutions in terms of investing because of that experience. So it does sort of sear in the memory of many investors.

And then on the other side of the coin, investors who have never experienced a loss in the bond market often are willing to take a lot more risk than you would think maybe is appropriate. They’ll go into high-yield bonds or leveraged funds, because they’ve never experienced that negative side of the bond market. And I’ve seen this with investors, particularly recently in the Puerto Rican bonds, because even though there was a lot of signs and a lot of warnings out there, they had been downgraded by the rating agencies to being speculative, and yet people just simply couldn’t accept the idea that they wouldn’t get paid back by a government entity. And they ended up, many of them, not doing well.

Mark: I’m glad you brought up Puerto Rico, because we get a lot of questions about municipalities who are issuing debt. And, as you know, individual investors make up a big percentage of the municipal bond market. So how serious are the challenges facing municipalities, and, you know, state and local governments that have issued bonds?

Kathy: Well, there are certainly challenges, and you know, we acknowledge them and we monitor them, but I think that they’re well managed in most cases. So we’ve got these highly publicized municipal defaults, like Detroit and Puerto Rico, over the last couple of years. So it might seem like credit risk is worsening in the municipal bond market, but it’s actually not been the case. The number of issuers that have missed regularly scheduled principal payments or interest payments has actually been declining since 2010⁵. So it’s as we come out of the financial crisis, municipalities and states are in better shape, generally speaking, and they’ve been able to make their payments. So over the long run, I think investors in the muni market really should, though, focus on areas, municipalities, where there’s a strong labor market, improving property values, that’s usually where the tax revenues come from for the entities. So those are two things to look for when you’re choosing municipal bonds.

Mark: And probably, also, as you mentioned before, conditions change. So you can’t just set it and forget it, so to speak. You got to pay a little bit of attention as can, you know, to ongoing changes in the environment.

Kathy: Yes, and as the economy goes up and down, so does the credit quality of, you know, various municipalities.

Mark: So, Kathy, in the pantheon of bond risks, where do you rank inflation as a risk?

Kathy: It’s very important. Some of what you get when buying bonds is generally just the interest payments and your principal back at maturity. So if inflation goes up, it erodes the value of the principal and interest payments that you get. So bonds can be very sensitive to changes in the inflation rate, especially longer-term bonds.

Mark: So one experience that is pretty vivid in the mind of older investors is the high rates of inflation we saw during the 1970s and early 1980s. But over the past 10 years, you know, frankly, inflation has been pretty low. So do you find sort of a generational divide when it comes to the level of concern that investors have about inflation?

Kathy: Yeah, I really do. You know, there are investors who have been avoiding long-term bonds because of worries about inflation for years, and to some extent, it’s a little bit like the general fighting the last war. Rate of inflation, as you mentioned, has been coming down steadily for the past few decades, and it’s kind of plateaued at a relatively low, historically low level over the past couple of years. And so, you know, by avoiding long-term bonds over the years, those investors did miss out on earning that higher income that comes with those larger interest payments from long-term bonds. So, for example, if you just bought three-month Treasury bills and reinvested the proceeds regularly over the past 30 years, your returns would have been significantly lower than if you had bought intermediate- or longer-term bonds and reinvested them over the years. In the Treasury bills, you would have realized an annual return of about 4%, which, you know, is not too bad, but if you had gone into 10-year Treasuries and reinvested over the years, your annualized return would have been quite a bit greater, been over 7%.⁶ And even with five-year bonds, which tend to be less risky than, say, 10-year, it would have been 5-1/2%⁷. So the point is that earning the higher income from longer-term bonds and compounding the investment of that income can make a really big difference.

Mark: So Kathy, there are a lot of different ways to protect against inflation risk, but within the confines of the bond market, how can an investor protect against inflation risk?

Kathy: Well, the most straightforward way is to invest in TIPS. That stands for Treasury Inflation-Protected Securities. These are bonds issued by the Treasury, so there’s no credit risk involved, but the interest payments and the principal are indexed to the Consumer Price Index, CPI. That’s the overall CPI—the one that includes food and energy. So every year the Treasury will look at the previous year’s inflation rate and then adjust the next year’s payments and the principal to compensate for it. The securities are really designed to keep pace with inflation, so it addresses that issue in the bond market.

Now a second consideration is to look for bonds with coupons that are higher than the current rate of inflation or the rate of inflation that you’re expecting. Typically bonds with higher coupons will trade at higher prices than lower-coupon bonds but getting those higher payments should let you re-invest at higher interest rates if inflation rises.

Mark: So we also have to decode not only biases, but some jargon. So within the confines of a bond investor, what do you mean by coupon?

Kathy: Yeah, it’s a term that actually goes back a long time. Originally bonds were issued as physical pieces of paper, and they would give you little coupon books for your interest payments and you would actually clip the coupon and take it somewhere, maybe the bank, and get your interest payment. And so we call the current rate that’s payed on the bond the coupon.

Mark: Great.

Mark: So your description of TIPS makes them sound really appealing. I get interest. I’m protected against inflation. What’s not to like?

Kathy: Well, TIPS tend to have low coupons, the amount you get paid in interest, so you won’t earn as much current income as you will in a regular Treasury bond. And, also, they’re still bonds, so they’re sensitive to changes in interest rates just like other bonds. And if inflation remains low, then, actually, TIPS might under-perform a regular Treasury bond. 

So we usually look at what’s called the break-even rate. That’s the average rate of inflation you would need to see over the life of the bond to make the return from TIPS the same as the return from a Treasury of comparable maturity. You can estimate, so what do you think inflation will be over, say, the next five years if you’re buying a five-year TIPS, and then you can look at whether the TIPS is going to be more attractive than the Treasury.

Mark: So what do you tell the listener, then, who isn’t concerned at all about inflation, you know complete indifference? Does that make sense?

Kathy: No, I mean, it is a big factor for the bond market, so you need to pay attention to it. I don’t, personally, think inflation is going to be a big risk in the near-term, but it’s certainly important to take into consideration when you’re building a portfolio. Most investors in the 1970s didn’t think inflation was going to get to be as high as it was, or ramp up and accelerate as rapidly as it did. So you do need to pay attention to it because it is a big factor in the bond market.

Mark: So another risk that investors face is duration risk. But before we get into the risk part, can you explain, hopefully clearly, what duration means?

Kathy: Yes, this is always a confusing concept. Duration is just a way to measure how much a bond’s price will fluctuate with a change in interest rates. So, in general, bonds with longer maturities will tend to have higher durations and bonds with shorter maturities will have lower durations. And, again, it’s a little confusing. The way I think about it is how soon are you getting your money back from a bond? So if it’s sooner rather than later, the duration is probably lower, and vice versa, if you have to wait a long time to get your money back, it’s probably got a higher duration. And, you know, the explanation is just when you buy a bond, all you get are really the interest payments at regular intervals and the principal back at maturity. So the sooner you get those cash flows back, the sooner you’re able to reinvest the money at higher interest rates if interest rates are going up. And if you have a long-term bond, you’re going to be waiting a long time to get your principal back, and if interest rates go up during the holding time you’ll probably miss out on that extra income. And that’s one reason long-term bonds will usually carry higher yields to compensate for the risk of tying your money up.

Mark: So as a practical matter, if you own a long-dated bond that’s got a lot of years to maturity, and interest rates go up, you’re going to see a much bigger price decline on your brokerage statement than you would see for a shorter-term bond that’s about to mature.

Kathy: Yes, that’s definitely the case.

Mark: So like credit risk, it’s hard to make sweeping general statements about whether this level or that level of duration is right for a specific individual. So how do you go about making that decision?

Kathy: Well, what we usually suggest is you try to match up the duration of your portfolio with your investing time horizon. In other words, if you’re investing in fixed income for the next five to 10 years, then you might want to consider investing in duration that falls in that range. It’ll be getting your money back when you need it. You can focus on, you know, on the investment goal, rather than on the fluctuation in prices in the interim.

But if you’re someone who can’t tolerate the ups and downs in the prices of your bonds, then you might want to keep the duration low. Alternatively, you can stagger the maturities of your bonds over time. We usually refer to this strategy as a bond ladder, and the way it works is you spread out the maturities evenly over time. Say, you have a 10-year time frame, you have a bond maturing each and every year, and that gives you sort of an average duration, maybe, that aims at your investing time horizon, and you don’t have to worry as much about the ups and downs in the market.

Mark: So we’ve talked about credit risk, inflation risk, duration risk. These are some of the big risks that a bond investor faces. But when I go to schwab.com and I look at the bond section, there are a lot of different terms and conditions that are attached to individual bonds that have their own complex nomenclature. So what are the most important ones that somebody should be paying attention to?

Kathy: Well, there is a lot to consider and there’s a fair amount of jargon in the bond market that can make it confusing. Every bond is pretty much unique—it has its own credit profile from the issuer, has its own yield, will have its own duration. Even bonds issued by the same entity, the same corporation, say, or municipality are going to have different terms and conditions. So some are backed by, say, a source of revenue, while some will be just an obligation, a general obligation of the issuer. Some are callable, meaning the issuer has the right after a certain time period to pay off the bond, to call it in. And that usually happens when the interest payments on the bond are higher than the prevailing interest rate in the market. So lots of factors to consider.

Mark: So let’s try to wrap this up and kind of tie it all back to where we started. I want to take less risk with my investments because I’m getting older, but I need income. And maybe I’m thinking about bonds for the first time. So give me three steps that would help me to determine how much risk I should take with my bond portfolio.

Kathy: Sure, I would say, when you’re investing in bonds, you want to consider how much risk of default am I willing to take, because that’s where you could actually lose money; then how much interest rate risk, or duration risk, am I willing to take; am I being compensated for the risk of inflation; and does it match up with my time frame?

Mark: That’s great advice, Kathy. Thanks for taking time to talk to us today.

Kathy: Oh, thanks for having me, Mark. This has been great.

In this episode we’ve tied together two important phenomena.

The first is the fact that we are in the midst of one of the great demographic transitions in U.S. history. The baby boomers are moving into retirement. One consequence of that transition is that millions of investors are starting to think about reducing the stock component of their portfolios and investing the proceeds in bonds.

That’s entirely appropriate, but bonds have their own risks, and these must be properly managed if you’re going to achieve your goals.

The second is the human tendency to allow our past experiences and the vividness of the stories we hear from others to influence our perception of risk.

As with any investment decision, everything comes down to finding that right balance between risk and the potential for return. If you’re moving toward retirement and starting to think about bonds, it’s important to base your considerations of the various risks on objective factors—and not be overly influenced by your past personal experiences or those of friends and family.

Now, that’s not to imply that you should pay no attention to salient experiences and events. What we are saying is that you shouldn’t pay disproportionate attention to them because they might not be a representative sample of what could happen based on current and expected future conditions.

A bond is essentially a loan. Of course it makes sense to be concerned about whether the bond you own will make interest payments and return your principal. But don’t let high-profile bankruptcies like Puerto Rico and Lehman Brothers frighten you into eliminating credit risk from your portfolio altogether. Credit risk can be managed via diversification as well as regular monitoring.

Inflation is the bane of the fixed income investor with good reason; however, don’t automatically assume that just because the U.S. has had bouts of inflation in the past that inflation is automatically guaranteed to return in the near future. And even if it does, there are mechanisms to blunt its influence (like using TIPS or shortening the maturity of your holdings).

As with all of the decisions that we cover on Financial Decoder, Schwab can help. If you’d like to learn more about bonds that Schwab offers or investing in fixed income in general, check out schwab.com/bonds.

On that page you’ll also find some great articles from Kathy Jones about how to develop your own bond-investing strategies.

Thanks for listening. If you’ve enjoyed this episode, consider leaving us a review on Apple Podcasts or your listening app.

For important disclosures and a transcript, see the show notes and schwab.com/financialdecoder.

¹ Samuli Knupfer, Elias Rantapuska, and Matti Sarvimaki, “Formative Experiences and Portfolio Choice: Evidence from the Finnish Great Depression,” Journal of Finance, February 2-17, pp. 133-166.

² Ulrike Malmendier and Stefan Nagel, “Depression Babies: Do Macroeconomic Experiences Affect Risk Taking?” Quarterly Journal of Economics, 2011, pp. 373-416.

³ Peter Koudijs and Hans-Joachim Voth, “Leverage and Beliefs: Personal Experience and Risk-Taking in Margin Lending,” American Economic Review, November 2016, pp. 3367-3400

⁴ Source: Moody’s Investors Services, as of 7/31/2018

⁵ Municipal Market Advisors, as of 1/25/19

⁶ Source: Schwab Center for Financial Research Calculations using data provided by Bloomberg. Calculations from 12/31/81 to 12/31/18. Calculations do not assume taxes. Assumes reinvestment of interest and principal payments.

⁷ Source: Schwab Center for Financial Research Calculations using the Bloomberg Barclays US Treasury 1-5 Year Index and the Bloomberg Barclays US Treasury Bellwethers 10-Year Index. Calculations from 12/31/81 to 12/31/18. Calculations do not assume taxes. Assumes reinvestment of interest and principal payments.