Fixed Income Risk
Manage fixed income risk using BondIT, the intelligent asset management software designed to reduce time and resourcing and deliver instantly compliant investment proposals while optimizing fixed income portfolio management. Our platform is designed to streamline your business workflows and reduce costs by managing fixed income risk effectively. It does this using leading data science and software development methodologies to produce a user-friendly interface for a powerful fixed income investment tool.
What is fixed income risk?
Fixed income risks can occur when the bonds market become unpredictable, affecting bond funds. There are all kinds of factors which contribute to the volatility of the fixed income trade market and it is the role of the portfolio manager to accurately manage and respond to fluctuations, suggesting bond allocation and investment strategies to not only meet the needs of their clients but to also exceed investment objectives and generate a high yield of corporate bonds, municipal bonds and government bonds. The largest fixed income risk comes from interest rate risk, reinvestment risk, credit risk, exchange rates, political events affecting the bond issuer as well as other risks like call/prepayment for callable bonds and liquidity risk. For example, if the interest rate environment offers a bond issuer the ability to reborrow at a better rate, then a callable bond – also known as a redeemable bond – can be redeemed before it reaches the stated maturity date. These types of bonds have a higher fixed income risk but also a higher yield so they must be managed carefully to ensure that a client’s investment objectives can still be met. Analysing the corporate bonds market is something that BondIT can help portfolio managers concentrate on with fully customizable fixed income analytics at their fingertips. Predict corporate bonds to buy in a matter of minutes.
Interest rate risk comes in two types: level risk and yield curve risk. Both of these types of risk can negatively affect the value of a bond as an interest rate rise can devalue the price of the bond. However, to better manage reinvestment risk, it’s beneficial that interest rates increase. This ensures that the investor receives a higher return.
The risk of a call or prepayment risk is that if the bond issuer utilizes their right to ‘call’ the bond before its maturity date. Purchasing individual bonds with a provision like this has three main disadvantages. There is a risk to the projected cash flows as that cash flow in interest payments may end earlier than expected as well as the risk of reinvestment. Calling a bond early usually occurs because there is a more favorable interest rate environment for the issuer, and they can borrow at a lower rate. When this happens, the reinvestment risk for the investor increases as it’s more favorable to make fixed-income investments during increases to the interest rate rather than decreases. Finally, when a bond is called early, the appreciation of the bond price will not exceed the price at which the issuer may call the bond.
Other fixed income risks may come in the form of credit risk and inflation risk. Credit risk is the risk that the issuer will not pay the principal or the coupon for the bond. It also relates to the risk of lower performance, depending on the performance of other, similar bonds. Inflation risk to fixed income securities comes when there is a possibility that inflation will devalue cash flow generated by the bond. When the coupon rate for a bond is 5% and the inflation rate is 8% – the coupon has comparatively less value. The interest rate or the coupon rate of the fixed income bonds is fixed so the rate of return is heavily influenced by inflation rates. Fixed income instruments help to effectively manage this risk.
Liquidity risk comes when the bond owner must sell a bond below its actual value. Liquidity can then be defined as the spread between the minimum price for which a seller is willing to sell a fixed income asset (the asking price) and the maximum price a new buyer is prepared to pay (the bid price). The higher the spread between the asking price and the bid price, the lower the liquidity and the higher the fixed income risk.
Political or legal risk can occur when actions taken by a government adversely affect the value of a fixed income high yield return. These actions include changing the tax rates or even changing the status of the taxable bond which was previously tax-free. A tax-free bond is more valuable when the tax rate is high as more investors will be looking for a tax-exempt bond than when tax rates are lower. Sudden changes to the tax rate can therefore increase or decrease the value of fixed income options.
Understanding the various fixed income risks affecting a fixed income fund enables investors and portfolio managers to better rate bonds, prepare for potential exposures and create contingency strategies to overcome losses and devaluation. BondIT is the intuitive asset management software designed to factor in fixed income risk and return investment strategies geared toward portfolio optimization. Construct optimal investment portfolios and manage existing portfolios quickly, efficiently and cost-effectively. Use BondIT’s ‘Solve Anyway’ function to produce strategies even when constraints are infeasible.
To understand how BondIT can help your business to better manage fixed income risk and generate optimal investment portfolios and fixed income ETFs for your clients, get in contact with one of the team today. Our asset management tool can help you increase efficiency while meeting and exceeding the investment objectives of your clients.