On "Concentration Risk" in Bond Investment [Bond Basics Series 93]

Hello.
I am Taisei Fujimura (https://twitter.com/wp_fujimura), an IFA for high-net-worth individuals at Wealth Partner (https://wealth-partner-re.com/).

"Bonds are safer than stocks, so it's okay to concentrate on one company, right?"

I sometimes encounter people with this mindset during consultations. It is true that bonds are lower-risk assets than stocks in the sense that principal and interest are protected as long as the issuer does not go bankrupt. However, the perception that "bonds are safe" can lead to complacency regarding concentration risk.

When the issuer is limited to a single company or concentrated in a specific industry, this "concentrated state" is structured so that the entire portfolio suffers significant damage when a single risk factor materializes.

In this article, I will organize the types of concentration risk in bond investment, the problems they actually cause, and how to deal with them.

(1) What is concentration risk?

A state where risk is "not diversified"

Concentration risk is the risk arising from a state where a portfolio is overly dependent on a single specific factor. When that factor moves in a negative direction, the entire portfolio suffers significant damage.

In stock investment, the concept of diversification—"do not invest all your money in just one company"—is widely known. However, in bond investment, this awareness of diversification tends to be weaker due to trust in their safety.

There are several reasons why complacency regarding concentration risk is more likely to arise in bond investment. First, there is the peace of mind that "the principal will be returned if held until maturity." Second, because prices do not fluctuate as wildly every day as they do with stocks, it is harder to feel the risk. And third, because interest (coupons) comes in regularly, the feeling that "things are going well" is easily maintained.

This psychological sense of security becomes the cause of leaving concentration risk unaddressed without realizing it. There are many patterns where concentration in an issuer progresses while thinking, "This company's bonds have a high rating, and the interest comes in properly every time. There shouldn't be a problem."

The nature of "bonds returning the principal if held until maturity" is true. However, this premise is conditional on "as long as the issuer does not go bankrupt." Furthermore, even if the issuer does not go bankrupt, there are multiple paths through which concentration risk can materialize, such as credit rating downgrades, deterioration of an entire industry, or large fluctuations in exchange rates.

Four types of concentration risk in bonds

Concentration risk in bond investment can be considered along four main axes.

Issuer concentration risk is a state where funds are concentrated in one specific company or a small number of issuers. Industry concentration risk is a state where issuers are biased toward a specific industry or sector. Currency concentration risk is a state where investment is biased toward bonds denominated in a specific currency. Maturity concentration risk is a state where maturities are concentrated in a specific period.

While these four have different types of risks, they can also influence each other. For example, a state where "maturities of foreign currency-denominated bonds in a specific industry are concentrated in the same period" is a concentrated state where three risks—industry, currency, and maturity—overlap. When designing a portfolio, it is important to check not just one, but all four axes simultaneously.

(2) Issuer concentration risk

The essential danger of concentrating on one company

The most fundamental concentration risk in bond investment is issuer concentration risk. If assets are concentrated in one company or a small number of issuers, the entire portfolio will suffer significant damage when a problem occurs with that issuer.

For example, if you had invested 100 million yen entirely in the bonds of one company, and that issuer defaults, the amount you can recover depends on the issuer's remaining assets. The recovery rate varies depending on the case, but in the worst-case scenario, there are instances where almost nothing can be recovered.

If you hold 10 million yen each across 10 different companies, the maximum loss from a default by one company is limited to 10 million yen (10% of the total). Since income from the remaining nine companies continues, the impact on the portfolio as a whole is limited.

While this difference is simple to see in numbers, when you are actually managing investments, the temptation to "concentrate in one company with a high yield" is strong. Especially with companies you trust or know well, it becomes harder to feel the need for diversification. The conviction that "this company should be fine" is often the biggest cause of overlooking concentration risk. It is a structure where the more knowledge you have, the more confidence you gain, and that confidence justifies concentration.

Cases of default that occurred even with high ratings

There is a school of thought that "if the rating is high, it is fine to concentrate," but historically, there have been multiple cases where companies defaulted while maintaining an investment-grade rating.

Enron (2001), as one of the largest energy companies in the U.S., maintained an investment-grade rating while massive accounting fraud was uncovered, causing it to rapidly lose creditworthiness; its rating was maintained until just before its collapse. WorldCom (2002) also maintained a high rating as a major player in the telecommunications industry while suddenly collapsing due to massive accounting fraud. Lehman Brothers (2008) held an investment-grade rating until September 2008, just before its collapse.

What these cases have in common is that "problems that were difficult to see from the outside had accumulated internally." Rating agencies perform evaluations based on public information, but accounting fraud and rapid deterioration of the business environment are difficult to grasp from disclosed information alone. These cases reiterate that ratings are merely "evaluations at the current point in time" and do not guarantee the future. While it is necessary to trust ratings, over-reliance on them is not a reason to justify issuer concentration.

Furthermore, ratings are often downgraded rapidly as a default approaches, and in practice, there are cases where responding by "selling after seeing the downgrade" is too late. The sense of security relied upon by ratings allows concentration risk to be ignored, and the development where losses have already ballooned by the time the problem becomes apparent is a pattern that has been repeated in the past.

Practical guidelines for issuer diversification

There is no single answer as to how many companies are enough to diversify into, but in practice, diversification into about 10 to 15 issues is often discussed as a balance between mitigating concentration risk and management costs.

If the ratio of a single issue exceeds 10%, it must be recognized as "intentional concentration." It is important to simulate in advance how much impact it would have on the entire portfolio if a problem were to occur with that issuer.

However, simply increasing the number of issues is not enough. Even if you are diversified into 30 issues, if they are all concentrated in the same industry, same currency, and same maturity, the risks of industry concentration, currency concentration, and maturity concentration remain. Diversifying issuers is the starting point, and it only becomes effective diversification when combined with diversification along the axes of industry, currency, and maturity, which will be discussed in the next chapter.

(3) Industry concentration risk

Even if you separate issuers, it is less meaningful if the industry is the same

Even if you have diversified into multiple issuers, if those issuers are concentrated in the same industry, the entire portfolio will be damaged simultaneously when industry-specific risks materialize.

For example, suppose you have diversified into bonds of 10 banks and financial institutions. The issuers are divided into 10 companies, but if a situation that affects the entire financial sector occurs (such as a financial system crisis like the Lehman Shock, or a blow to bank management due to rapid interest rate changes), the credit spreads of all 10 companies may widen simultaneously, causing prices to fall.

The collapse of Silicon Valley Bank (SVB) in March 2023 is a typical example. Triggered by the collapse of SVB, caution toward financial institutions as a whole increased in the market, and financial sector bonds were widely sold regardless of the financial condition of individual companies. Furthermore, this turmoil spread to Europe, and Swiss financial giant Credit Suisse was rescued and merged into UBS. At this time, the subordinated bonds unique to financial institutions called AT1 bonds (CoCo bonds) issued by Credit Suisse became completely worthless, and investors around the world suffered losses due to the price decline of AT1 bonds as a whole. For investors who were concentrated in "high-yield financial institution bonds" known as AT1 bonds, this is a case where losses materialized in a form where industry concentration and bond type concentration overlapped.

Risk drivers differ by industry

The reason industry diversification is effective is that the causes (drivers) of risk differ by industry.

The energy sector is heavily influenced by fluctuations in crude oil and natural gas prices. The financial sector is strongly influenced by the interest rate environment, credit cycles, and regulatory changes. The manufacturing industry is affected by business cycles, supply chain issues, and fluctuations in raw material costs. Telecommunications and utilities are relatively stable, but regulatory changes and capital investment cycles affect their performance. Consumer staples are less affected by economic fluctuations and are characterized by relatively stable earnings.

By diversifying into industries with these different risk drivers, a structure is created where if one industry deteriorates, another industry remains stable. Even if energy prices plummet, the impact on telecommunications and utilities is limited. Even if the financial sector is in trouble due to rising interest rates, issuers in the consumer staples sector are relatively less affected. Even if the risks of a specific industry materialize, the damage to the entire portfolio can be suppressed.

Another important point is the correlation between industries. During an economic recession, many industries deteriorate simultaneously, but among them, there are industries with relatively smaller impacts (such as consumer staples and utilities, known as defensive industries) and those with larger impacts (such as cyclical energy and manufacturing industries). Diversifying among industries that move similarly in both boom and bust cycles provides little true diversification benefit. The perspective of "combining industries that move differently in each economic cycle" enhances the quality of industry diversification.

Patterns where industry concentration is likely to occur

In practice, there are patterns where industry concentration tends to progress unknowingly.

One is the pattern of "gathering in industries with high yields." In a low-interest-rate environment, capital naturally flows toward industries or bond types that offer relatively higher yields. Just as financial institution AT1 bonds offered high yields at one time, there are many cases where concentration in specific industries or specific bond types progresses in search of yield. There is a reason for high yields, and that reason is often derived from high risk. Confirming "why the yield is high" is the first step to understanding the gateway to industry concentration risk.

Another is the pattern of "gathering in familiar industries." When choosing companies in industries that you know well or understand easily, you may end up biased toward a specific industry without realizing it. This is the case when someone knowledgeable about the real estate industry chooses mainly real estate-related corporate bonds, or someone from the financial industry holds mainly financial institution bonds. The structure where having knowledge creates a sense of security, and that sense of security justifies concentration, is the same as the issuer concentration pattern.

When adding issues, it is important to confirm which industry the new issue belongs to and to regularly check whether the ratio to a specific industry is increasing.

When I actually see a client's portfolio for the first time, I sometimes encounter cases where, although there are more than 10 issues, the financial sector alone accounts for more than half when organized by industry. The client recognized that "it is diversified because it is divided into multiple companies," but from the perspective of industry, it was concentrated. I feel that the gap between "intending to diversify" and "actually diversifying" often only becomes visible when you check the axis of industry.

(4) Currency Concentration Risk

Foreign currency-denominated bonds have another concentration risk called "exchange rate risk"

When holding foreign currency-denominated bonds, exchange rate fluctuation risk is added in addition to the credit risk of the bond itself. If you are concentrated in a specific currency, such as the dollar or euro, the yen-converted value of the entire portfolio will decrease when that currency falls significantly.

For example, if all foreign currency-denominated bonds were held in dollars, if the yen appreciates significantly, the asset value in yen terms will decrease significantly even if the bond itself has not defaulted. In 2022, the yen depreciated to the 150 yen per dollar range, but in situations where the opposite movement occurred (such as the rapid yen appreciation after the Great East Japan Earthquake in 2011), the yen-converted assets of investors who were concentrated in foreign currency-denominated assets decreased significantly.

There are two ways to deal with currency concentration risk. One is diversification into multiple currencies. By combining bonds denominated in multiple currencies such as the dollar, euro, pound, and Australian dollar, you can limit the impact that large movements in a specific currency have on the entire portfolio. The other is currency hedging. By applying currency hedging, the impact of exchange rate fluctuations can be almost neutralized, but hedging costs (expenses linked to the interest rate differential between Japan and the US) are incurred. Currently, because the interest rate differential between Japan and the US is large, the currency hedging cost for dollar-denominated bonds is at a level that cannot be ignored. Whether it is more advantageous to hedge or not depends on the level of the interest rate differential and market outlook, so it is difficult to judge uniformly, and a decision based on your own risk tolerance and outlook on the currency is necessary.

(5) Maturity Concentration Risk

What happens when maturities are concentrated in one period?

Maturity concentration risk is a risk that arises from a state where the maturities of the bonds you hold are concentrated in a specific period.

When maturities are concentrated in one period, a large amount of funds will be returned at that timing. Even if you try to reinvest at that time, it will be affected by the interest rate level at that point. If a low-interest-rate environment continues, you will be forced to reinvest a large amount of funds at a low yield.

For example, if the maturities of all 10 issues were concentrated 3 years from now, and the interest rate environment 3 years from now is significantly lower than it is now, a situation will arise where the entire 100 million yen must be reinvested at a low yield. If you diversify the maturities, only a portion will reach maturity each year, and the impact will remain limited.

The opposite perspective is also important. In a situation where interest rates are rising, if you hold a large amount of bonds with long fixed maturities, unrealized losses will expand on a market valuation basis. Since the price fluctuation due to interest rate changes is larger for long-term bonds (the duration is longer), "concentrating on long maturities" itself is a risk. Depending on which maturity you concentrate on, long-term bonds become a problem when interest rates rise, and reinvestment of short-term bonds becomes a problem when interest rates fall. Maturity diversification is a structural preparation to limit the impact regardless of which direction interest rates move.

Diversifying maturities with a ladder-type design

An effective measure against maturity concentration risk is a design method called a ladder-type portfolio. By combining bonds with different maturities, such as 1 year, 3 years, 5 years, 7 years, and 10 years remaining, you create a structure where a portion of the bonds reach maturity every year.

There are several advantages to this design. First, the risk of a large amount of capital maturing during a period of low interest rates is reduced. Second, during periods of rising interest rates, maturing capital can be reinvested gradually at higher yields. Finally, by having a certain amount of capital return from maturities each year, liquidity is also naturally secured.

As a more practical application, if you have funding needs at a specific time in the future (such as children's education expenses, business investments, or inheritance tax payments), you can combine bonds that mature at that time to ensure planned funding. By designing the maturities to match your cash flow outlook—not just in terms of "when" and "how much" is needed, but also by diversifying—the portfolio begins to function as a tool for asset management.

A ladder-type design is not finished once it is built. Every year, you must make a decision on where to reinvest the capital that has reached maturity. You repeat the cycle of choosing the next investment destination while checking the interest rate level, credit environment, and the overall balance of your portfolio at that time. The secondary effect is that the creation of these "regular decision-making opportunities" itself becomes a trigger for continuously reviewing your portfolio.

(6) Practical methods for managing concentration risk

Checking concentration when making new investments

It is important to make it a habit to always check the impact on concentration when adding new bonds. Even if you find an issue with an attractive yield, if adding it increases concentration in a specific issuer, industry, currency, or maturity, you should make your decision with an awareness of that impact.

It is practically important in managing concentration risk to always have the perspective of "how will the balance of the entire portfolio change by adding this issue," rather than just the judgment of "I will buy it because it is a good issue."

The perspective for evaluating individual issues is different from the perspective for designing the entire portfolio. Even if an individual issue is attractive, if you add it while concentration in the same industry or currency is already high, the overall risk increases. The question "Is this issue good?" and the question "Should I add this issue to this portfolio now?" are different questions. Always being aware of the latter question in investment decisions leads to practical management of concentration risk.

Distinguishing between intentional and unintentional concentration

There is one point that must not be forgotten in the management of concentration risk. That is the point that not all concentration is bad.

If you have strong conviction or specialized knowledge about a specific issuer or industry and are intentionally increasing the ratio, that is "strategic concentration." In that case, it is a prerequisite to have clearly defined the reason for the concentration, countermeasures in case the assumed scenario does not occur, and the maximum acceptable loss amount.

The problem is "unintentional concentration." This is a pattern where dependence on a specific factor increases without you noticing, and you only realize you were concentrated when the risk becomes apparent. Maintaining a state where you can ask yourself "Why do I hold this issue?" and "Is this ratio intentional?" is the basis for distinguishing between intentional and unintentional concentration. Regular concentration checks are a mechanism for discovering this unintentional concentration early.

(7) Summary

Concentration risk in bond investment exists along four axes: issuer concentration, industry concentration, currency concentration, and maturity concentration.

Issuer concentration risk is the most fundamental risk, and a default by one company can cause significant damage to the entire portfolio. Even if the rating is high, issuer concentration is dangerous, as past cases have shown.

Industry concentration risk occurs if industries are biased even if issuers are divided into multiple entities. In situations where industry-specific risks chain together, such as the contagion to the entire financial sector after the SVB collapse or the total write-down of Credit Suisse's AT1 bonds, diversifying only by issuer cannot cope. By diversifying into issuers with different risk drivers for each industry, you can limit the impact that the deterioration of a specific industry has on the entire portfolio.

Currency concentration risk arises from concentrating foreign currency-denominated bonds in a specific currency. It can be controlled by diversifying into multiple currencies or by utilizing currency hedging while taking hedge costs into account.

Maturity concentration risk is the risk of being greatly influenced by the interest rate environment at the time of reinvestment because maturities are concentrated at a specific time. A ladder-type design that spreads out maturities and creates a structure that matures periodically is an effective countermeasure.

Concentration risk management can be handled through three practices: regular concentration checks, confirming the impact on the entire portfolio when making new investments, and distinguishing between intentional and unintentional concentration. It is true that bonds are "safe assets," but in a concentrated state, safety is greatly compromised. Designing for diversification is a prerequisite for truly utilizing the safety of bond investment.

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