White paper: When can risk mean opportunity?

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Gene Tannuzzo, CFA, Global Head of Fixed Income

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There’s more to bond investing than interest rates. And understanding the four key risk factors can help investors navigate the fixed-income market.

A basic principle of fixed-income investing is that when interest rates rise, bond prices fall, and vice versa. And this interest-rate risk, or duration risk, is what most investors think of when investing in bonds.

But the fixed-income market is more complex than that, and there’s more than just interest-rate risk to consider. By breaking bonds down to their most basic components, today’s investors can gain a better understanding of the factors that generate risk and return. A better understanding of these drivers can help investors navigate changing market conditions.
 

Understand the risk factors in the bond market


A risk factor is an independent market variable that helps explain the return of an investment. While “risk” often carries a negative connotation, it also represents positive return potential. In the bond market, there are four unique, major risk factors that can drive performance:

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Duration or interest rate risk, represents the price volatility of a long-term investment as prevailing market interest rates change. Currency risk is driven by fluctuations in exchange rates. Credit risk represents the risk of default for lending to a private corporation, consumer or risky sovereign country. Inflation risk is driven by actual and expected changes in consumer prices.


Emphasize different risks at different times

Not all bonds respond to these risk factors in the same way. Each risk factor is unique, and bonds that are sensitive to these four basic risk factors behave differently in the various phases of the economic cycle. For example, credit risk is more attractive in periods of strong economic growth, but it’s less attractive when economic growth is slowing, which causes financial conditions to tighten and default risk to rise.


Bottom line

Depending on where we are in the economic cycle, different types of bonds offer opportunities beyond only duration. A flexible fixed-income strategy can find the right mix of risk, and potential opportunity, as market conditions change.

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