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Posted by Mike Larson


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How to identify — and neutralize — your fixed income risk!

by Mike Larson on February 15, 2013

in Commodities, Stocks, Technical Analysis

Martin D. Weiss, Ph.D.

The fixed income world can be a difficult place to navigate, even for experienced investors. And frankly, a lot of the advice you get on TV and from other sources just isn’t helpful. It simply won’t help you protect yourself from the bond market rout that’s already under way!

So here in Money and Markets, I’m going to do my dead level best to take a different approach — showing you how to identify … and NEUTRALIZE … your bond market risk!

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How much risk are you taking with your fixed income portolio?

ThreeKey figures that show how much risk YOU have in your fixed income portfolio!

When it comes to analyzing a stock, you probably research fundamentals like price-to-earnings ratios, sales and profit growth rates, dividend yields, and more. You may also use charts and technical analysis to identify optimal entry and exit points.

With bonds, there are three important things to look at when it comes to identifying your interest rate and credit risk. The good news? For mutual funds and exchange traded funds, it’s pretty easy to do so.

Your fund sponsor will gladly provide you with two key statistics: “weighted average maturity” and “average duration.” (These figures can also be found online.)

Key figure #1—

Maturity

The maturity figure tells you how long the bonds in the fund will take to close out, or mature. It’s expressed in terms of years, such as 4 or 5. The figure is further adjusted to account for the dollar sizes of each bond position.

Key figure #2—

Duration

Duration is another useful statistic. It’s a rough measure of how much a fund will decline in price for every percentage point rise in interest rates. For instance, a duration reading of 10 years means a fund will lose roughly 10 percent of its value if rates rise by 1 percentage point.

The higher the weighted average maturity of a fund, and the higher its duration, the greater the interest rate risk you’re taking on by owning it!

Key figure #3—

Credit breakdown

As for credit risk, the best way for you to gauge it is to look at the credit rating breakdown of the bonds in your fund or ETF. The higher the ratings (Aaa, Aa, etc.), the less credit risk you’re taking on. Anything below “BBB” from S&P or “Baa” from Moody’s is considered high-yield  or “junk” — the kinds of bonds I’ve been warning about most.

Take a look at this snapshot from the web page for the Vanguard Total Bond Market ETF (BND), and you’ll see what I’m talking about.


Click for larger version

Source: The Vanguard Group, Inc.

Using these tables, you can see that the average maturity of the bonds in BND is 7.1 years, and the average duration of the ETF is 5.2 years. U.S. government bonds make up 68.5 percent of the portfolio, followed by corporate bonds with a variety of ratings. This fund in particular has 4.1 percent of its money in Aaa-rated bonds, and 11.3 percent in Baa ones.

Armed with this information, you’re

ready to “scrub” your portfolio!

So now you know why I believe bonds are at risk of a significant sell off. And you know how to find key information that identifies the risk of bond mutual funds and ETFs. The next step is to “scrub” your fixed income portfolio in order to neutralize those risks.

Specifically, I recommend you look to eliminate funds or ETFs with average maturities and average durations of 2 to 3 years or more. I also recommend you get out of funds whose holdings are concentrated in the junk sector.

This will put you in better shape to weather the bond market turmoil I’ve been warning you about! I recommend you take action as soon as possible.

Until next time,

Mike



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