How Interest Rate Hikes Effect Your Bond Portfolio
Duration is a number most people do not associate with bonds and their value.
Duration is not merely a measure of time but a signal as to how much the price of your bond will fluctuate when there is an up or down movement in interest rate.
The sensitivity in the duration number is determined by how high or low that number is. The higher the number the more sensitive the bond will be to changes in the interest rates. As we all know, interest rates are near historic lows. Many economists believe interest rate will probably not get much lower but instead will eventually begin to rise. If that happens, outstanding bonds with low interest rates and a high duration number will experience significate price drops. As an example: bond funds holding long term bonds will most likely decline, possibly significantly, when interest rates begin to rise.
Interest rates are just one of many factors impacting bond prices. The rule of thumb is when interest rates rise, bond prices fall and vice versa. Duration risk is the name given to the risk associated with the sensitivity of the bond’s price to a 1% change in interest rate either up or down. A higher sensitivity indicates a higher duration. What this simply means is that fluctuation in price, whether it be positive or negative, will be much more pronounced if you have a higher duration. Holding the bond to maturity will produce the par value of the bond when your principle is repaid, unless the company fails. If you decide to sell early, before maturity, the price you will receive will be affected by the prevailing interest rate, and the duration risk. As an example, a medium investment grade corporate bond with a duration of 8.4 (10-year maturity, 3.5% coupon) could lose as much as 15% of its market value with a simple 2% interest increase. Similarly, an investment grade bond with a duration of 14.5 (30-year maturity, 4 ½ % coupon) might experience a loss as much as 26%.
Bond funds suffer the same affects due to duration. As an example, if a funds duration is two years then a 1% rise in interest rates will result in a 2% decline in the bond funds value. There are other variables such as the amount of interest a bond pays during its life span, as well as the bonds various cost features and yield. In addition, changes in credit quality will also play a role in the duration along with maturity.
The key to how your bond or bond fund will react with interest rate changes can be predicted by the duration. In order to find the duration, research the funds Fact Sheet, typically found in the Bond Holding Statistic section. When all else fails start by asking your investment professional or the bond issuer.
There are various duration numbers such as:
1. Macaulay duration, which calculates the bonds basic duration.
2. A modified duration is Macaulay’s computation which directly measures price sensitivity.
3. Effective duration is the calculation typically sited for bonds which have features that change when interest rates change such as redemption features.
Not all bonds will react the same way. As an example, an investment term, “convexity,” is used to describe the relationship as to how the duration will affect certain bonds. By way of example, if interest rates drop a residential mortgage back security (a bond backed by home loans) may not see any “increase” in the bond’s price due to the fact this might prompt home owners to refinance their loans which in turn may limit the increases in the bonds price, as it loses interest paying loans.
Lastly, do not be fooled by a low duration as it does not necessarily mean a low risk. Additionally, duration is not the only risk to be concerned with. Bonds and bond funds are also subject to inflation risk, call risk, default risk and other risk factors.
Please consult your investment advisor or give me a call if you have any questions and would like to see how you may protect and/or guarantee an alternative bond approach.