Ever since the first seemingly savvy saver stashed cash underneath a mattress, investors have turned toward safe harbors to help protect their hard-earned dollars.
But despite a generally held belief, fixed-income investments and other finance fortresses aren’t foolproof in today’s turbulent market. There are hidden risks in seemingly sturdy spots — even holding cash — that could threaten the ongoing maintenance of your current standard of living.
“Sometimes when people think things are safe, they’re overlooking risks that are inherent,” says Brian Rehling, CFA®, Wells Fargo Investment Institute Co-Head of Global Fixed Income Strategy, who shares these helpful tips for investors navigating the fixed-income market and beyond.
“You may have potentially bought a bond that won’t make its payment,” explains Rehling of one risk some investors aren’t aware of. “We tend to see this risk highlighted for lower-credit-quality, high-yield bonds.” As credit ratings decline the probability of default increases: Doing your research can help you weigh the pros and cons and properly evaluate. “The higher the extra yield you’re receiving, the bigger the risk,” says Rehling. “Clients should remember that not all bonds make their payments.”
How to mitigate this risk: Diversify and consider investment-grade bonds over high-yield bonds.
Several factors have aligned — including the risk-averse behavior of global consumers and businesses eyeing their balance sheets — to reduce expectations of significant inflation in the near future. Still, if you’re planning to live off your bond income, you should be wary of this possibility, says Rehling. “One of the risks of owning bonds, especially for investors locked into a longer stream of payments, is that inflation will be higher than expected, so the stream of payments buys less than it otherwise would have.”
How to mitigate this risk: Consider bonds with shorter maturities. Investors may also consider looking into U.S. Treasury Inflation-Protected bonds (TIPS), because with this investment, when the Consumer Price Index rises, the principal automatically adjusts. Think twice before locking in bonds for 20 or 30 years, adds Rehling.
Interest rate risk and call risk
There’s an inverse correlation between interest rates and bond prices, meaning that as interest rates go up, prices go down. Clients who are carefully examining their statements and are concerned about price fluctuations are advised to be cautious. Interest rates also affect issuers of callable bonds, who have the option of repaying the bond early if interest rates decrease, stopping regular payments and most likely leading to a new bond with a lower interest payment.
How to mitigate this risk: Diversify your income sources, avoid becoming dependent on monthly income from bonds.
“We’ve been talking about this one a lot recently,” says Rehling, who explains that Treasury bonds and bonds issued by big corporations tend to be more liquid, which is of interest to a slew of active investors. So, as with the stock market, if many people start to sell bonds as interest rates rise, values could drop further. On the other hand, if you’re trying to sell a less liquid bond, such as a municipal bond, you won’t find as many potential investors during times of stress, which could result in a lower price if you’re forced to sell because you need access to cash.
How to mitigate this risk: Time the maturities of your bond portfolio to match anticipated liquidity needs.
Whether it’s bundled up in bills in the bed or in a bank, good old-fashioned cash can still be a risk. “The problem with cash is that it yields almost nothing today, because the rates are so low,” says Rehling. “At a 1.5% or 2% inflation rate, you’re slowly losing purchasing power.” That’s likely to be the case for a considerable period of time, he adds.
How to mitigate this risk: Examine your portfolio and determine how to hold reasonable (rather than excess) amounts of cash to meet near-term liquidity needs and emergency expenses while still giving you opportunity to invest in higher-growth assets.
Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (“WFII”). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.
This article was written by/for Wells Fargo Advisors and provided courtesy of Darrin Haubert, Associate Financial Advisor, 1041 South Main Street, Bellefontaine, Ohio, at 800-593-4627.
Investments in securities and insurance products are: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE
Investment products and services are offered through Wells Fargo Advisors Financial Network, LLC (WFAFN), Member SIPC. Katterhenry Investment Group is a separate entity from WFAFN.
©2016 Wells Fargo Advisors, LLC. All rights reserved. 0515-01621 (93186-v2) 04/16