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By Christine Benz and Eric Jacobson | 02-04-2013 01:00 PM

How to Assess Bond Risks in Your Portfolio

Bond-fund investors need to focus on duration, credit quality, and relative yields to better understand how much risk they're taking on, says Morningstar's Eric Jacobson.

Christine Benz: Hi, I'm Christine Benz for With bond yields as low as they are right now, many investors are concerned that rising bond yields could hurt bond prices. Joining me to discuss how to assess the risks in your bond portfolio is Eric Jacobson. He is a senior analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Hi, Christine. Good to talk to you.

Benz: Eric, we usually think of there being too key risk metrics that you want to focus on when evaluating a bond fund: the interest-rate sensitivity and the credit quality. Let's start with interest-rate sensitivity, and one of the statistics we provide on is duration. A lot of people are looking hard at duration these days. Let's talk about what that measure is and how it may indicate whether a portfolio is risky or maybe a little less risky?

Jacobson: We'll as lot of folks know, duration is an estimate of how much interest-rate sensitivity your portfolio is going to have should market yields move up or down. Generally speaking what you want to do is look at the duration number, let's just say for example that it's 2.5 years, and multiply that by 100 basis points, or 1%.

What we at that point say us if interest rates move up, for example, 1 full percentage point, you would expect the fund to lose about 2.5% based on that duration and vice versa. Now, the most important thing I think for a lot people to realize is, it's not a foolproof number. It's a mathematical construct. It is a modeled number. It isn't perfect, and it doesn't necessarily account for changes in interest rates in every scenario. Sometimes, it's because shorter rates move up. Sometimes, it's because longer rates move down, things like that, but it is a pretty good estimate of what you can expect in a short shock of interest rates in one direction or the other.

Benz: So, the thing is though if interest rates move up, I get some of that back in the form of a higher yield. So, even if my principal values on my bonds might be depressed in my portfolio, my manager or I, if I'm buying individual bonds, am able to obtain new bonds with higher yields attached to them, right?

Jacobson: That's right, and you know, there are studies out there--Vanguard has had one from a couple of years ago, for example--that show different interest rate paths and how portfolios tend to recover reasonably quickly from interest-rate shocks. We should be careful not to try and scare people too much over the longer term. You're generally going to make out OK with your bond portfolio, but I think the one thing people need to realize is if under certain scenarios, if we do have a quick and large rate shock, you are going to have a period of perhaps very poor performance in a bond portfolio.

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