Baby Boomers are coming face to face with the realities of retirement, and their financial advisers are having to dig deep to come up with strategies that will calm their fears of a recurrence of the financial meltdown of 2008. In this climate, one term that comes up repeatedly is fixed income, which usually means bonds. Here, it is interesting to note that even fixed is not as certain as it sounds. Prices and rates of return for bonds vary over time and in opposition to those of equities. Even given this dynamic, the challenge for bond fund managers is essentially the same as for equity fund managers–how to diversify a portfolio’s holdings to minimize risk and optimize return.
In 2008 and early 2009 the the credit risk of corporate bonds was painfully in evidence, and since then financial planners have been sharpening their credit risk management tools to stabilize returns on bond portfolios. It has been generally accepted by investment professionals that the greater the number of financial instruments in a portfolio, the broader the spread of credit risk. A recent credit risk analysis by the BondDesk Group found, however, that spreading risk over an increasing number of investments is effective only up to a point, after which further investments offer no further protection against loss.
The BondDesk Group used Monte Carlo simulation software to determine two values, tail risk (loss of 20%) and black swan risk (loss at a catastrophic level of 50% or more), in portfolios that progressively increased in size from 2 to 50 bonds. Taken together the two measures of risk predicted which bonds would default. Interestingly, the simulations revealed that both kinds of risk were reduced by increases in portfolio sizes up to 10 bonds, and in both cases, these benefits began to diminish with bond number 11.
The group’s credit risk analysis brings good news for both investment advisors–it simplifies their work–and investors–it reduces the cost of investing! For the juicy details, go to the BondDesk website.