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Managing Fixed Income Risks in 2011

Understanding interest rate and credit risk // Evaluating your portfolio // How to take action

Fixed income securities have traditionally played a very important role in investors’ portfolios and, just like the other aspects of a well maintained investment plan, they should be reviewed regularly to ensure their appropriateness. Today’s market is presenting investors with a number of challenges that should be considered when evaluating their fixed income holdings, most predominantly interest rate and credit risks.

In this article, we’ll discuss the risks present in today’s market as well as a number of steps and strategies that can be taken to help address these risks.

Interest Rate Risk

As economic conditions continue to improve, interest rates are likely to rise and investors may have reason to be concerned about potential declines in the value of their fixed income investments. Remember, as interest rates rise, bond prices typically decline, and vice versa.

Credit Risk

The safety of your fixed income principal depends on the issuer’s credit quality and ability to meet its financial obligations, such as payment of coupon and prepayment of principal at maturity. It is important to note that credit risks aren’t limited to an issuer declaring bankruptcy or missing a payment. A change in either the issuer’s credit rating or the market’s perception of the issuers future prospects can affect the value of its outstanding securities and investors can see their bonds decline in price as a result. Ratings are not a recommendation to buy, sell or hold, and may be subject to review, revision, suspension or reduction and may be withdrawn at any time.

Current Concerns with Municipal Bonds
The economic environment of the last several years has negatively impacted revenue streams for municipalities, creating concerns about and increased media focus on the ability of some municipal bond issuers to satisfy their debt obligations. Historically, however, highly rated municipal issuers have demonstrated excellent financial strength. They’re generally considered second only to U.S. Treasury securities with respect to consistently satisfying their debt obligations and overall, that hasn’t changed.

As mentioned earlier, the press has painted a fairly alarming picture of the municipal credit landscape. While there is an emerging fear of defaults, this is historically a very rare occurrence in the municipal bond market.  In fact, most municipalities will raise fees and cut spending in areas of personnel and capital projects before they cut bond payments.

 Understand What You Own and Why You Own It

It’s important to reaffirm why you own fixed income investments and the role they play as a part of your overall asset allocation. You should also evaluate your risk tolerance in view of recent equity market volatility and the risks that may be present going forward.

Certain risks will impact you differently depending on your objectives and the types of investments you own.

When investing in bonds, you typically have three main options: Individual Bonds, Bond Funds and Managed Accounts. Each of these options has different characteristics and risk profiles, so it is important to understand how each will be impacted by certain situations and how that will affect you given your reasons for owning bonds.

Individual bonds have long been the traditional option for fixed income investing, but for many, bond funds have become a popular choice for diversification and professional money management with a lesser required investment. Bonds may also be purchased as part of a Separately Managed Account (SMA), through which portfolio managers select bonds to be owned by the investor directly.

With bond funds, price fluctuations in net asset value (NAV) will generally occur in response to changes in interest rates and credit quality. For example, increases in interest rates will generally deplete the NAV of bond funds. Unlike with individual bonds, an investor in bond funds does not have the option to hold bonds to maturity to collect par value.

If you own bonds to receive consistent income, you may plan to hold your individual bonds to maturity for full return of the par value. In this scenario, you may not be overly concerned about price fluctuations in the value of your bonds caused by changes in interest rates. Your priority may instead by to assure the credit quality of your investments.

It is also important to understand there are tradeoffs with every decision you make in your portfolio. You may often find yourself trading one risk for another. For example, when considering a reduction of interest rate risk in your portfolio, you may assume larger amounts of other risks. Shorter maturity bonds of similar qualities will typically have a lower yield. Higher yielding bonds of similar maturities generally present higher credit risk. Non-dollar investments such as foreign bonds carry currency risk as well as geopolitical risks. Diversifying the risk components of your fixed income portfolio and matching them to your personal circumstances will be critical moving forward.

Take Action

While we do not recommend dramatic changes to fixed income allocation based upon day-to-day market movements, there are a number of strategies available that my help manage risks. These include shortening your average duration, diversifying holdings among issuers and managing credit quality – among others.

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