Higher Yield Can Mean Higher Risk

August 9, 2012

Many investors turn to bonds or bond funds because they have historically been less volatile than stocks. But investors who select bond funds based only on yield may end up taking on more risk than they’d anticipated.

There are two likely reasons why a fund may have a higher yield than other funds: either the higher yielding fund invests in low credit quality bonds, which means the fund has a higher risk of default, or it invests in bonds that have a longer time to mature, which means the fund has higher interest rate risk.

You can see this in the NoLoad FundX bond listings: the bond funds with lower average credit ratings (BB or B) offer higher yields than the funds with higher credit ratings (BBB, A or AA). Bonds with lower credit quality may be more susceptible to being hurt if economic conditions weaken, because a slump in profits could impact a company’s ability to pay interest on its debt.

Funds with longer average duration (5, 6 or 7 years) have higher yields than those with shorter duration (1, 2 or 3 years, for example). The trade-off is that a bond or bond fund with a longer maturity or duration is more susceptible to rising interest rates. If rates rise, a bond that matures in 10 years will fall in value more than a bond that matures in two years.

 

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