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Managing Interest Rate Risk

| April 25, 2018
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Uncertainty in regard to the movement of bond prices has been a topic of debate ever since 2008, when in response to the great recession, interest rates were lowered to unprecedented levels in order to spur economic activity and growth.

And now that interest rates finally seem to be consistently on the rise (at least for now), bond prices have been nothing short of volatile.

Interest Rate Risk

Interest rates and bond prices have an inverse relationship.  When interest rates rise, bond prices fall (and vice versa).  The concept is simple when you think about it:

If you buy a 5% bond at par value of $1,000 and six months later similar bonds are issued at 6%, your 5% bond would be less valuable.  If you wanted to sell your 5% bond on the open market, you would have to sell it at a discount to entice a buyer to buy your 5% bond over a newer 6% bond issue.

The risk of a bond decreasing in value due to rising interest rates is called “Interest Rate Risk”, and as stated before, is a risk that has been routinely discussed over the past decade as interest rates have been at historically low levels.  However, only recently, have we felt a large impact of rising interest rates on bond prices. 

Rising Interest Rates

The Federal Reserve has kept interest rates low in order to encourage lending, spending and to stimulate the economy.  And while their goal since 2008 has been to eventually get interest rates back to normal levels, they have been very cautious in their approach.  Since 2008, when rates were lowered to 0%, the Federal Reserve has instituted six interest rate increases[1]:

12/17/15:        Increase from 0% to 0.25%

12/15/16:        Increase from 0.25% to 0.50%

03/16/17:        Increase from 0.50% to 0.75%

05/15/17:        Increase from 0.75% to 1.00%

12/14/17:        Increase from 1.00% to 1.25%

03/22/18:        Increase from 1.25% to 1.50%

With four of the six increases instituted over the last year, and at least two more expected by the end of 2018, the recent drop in bond prices makes sense.

Assuming the economy keeps humming along and the interest rate hikes by the Federal Reserve continue as planned, investors should be asking themselves two questions:  1) How much will bond prices be affected, and 2) How can you position a bond portfolio to mitigate the interest rate risk?

The answer to the first question is yet to be determined.  Trying to guess the short-term fluctuation of bond prices is similar to trying to guess what the stock market will do in the short-term.  There are too many factors, variables, and unknowns.  Yes, we do know that as interest rates rise, bond prices will fall, but we don’t how fast and how high the Federal Reserve will actually raise rates.

The answer to the second question is much simpler.  During rising interest rate environments, certain types of bonds are affected less than the others.  And while we cannot predict the timing of a decline in bond prices, we can predict, somewhat, how different types of bonds will respond.

Duration

Two factors of a bond will largely determine how the bond responds to rising interest rates:

  • Time to maturity
  • Coupon rate

Time to Maturity

The longer the maturity of a bond, the greater interest rate risk, or chance the price of a bond will fall when interest rates rise.  This makes perfect sense.  Think about it this way:

Assume you buy two bonds. You bought both bonds for $1,000 and they both have a coupon rate of 5%.  The only difference between the two bonds is one matures in 10 years and another matures in 5 years.  Now assume interest rates rise, and similar bonds are now being issued at 6%.  Which one of your two bonds is more valuable?  The 5-year bond, simply because you are not locked into the lower interest rate as long as you are with the 10-year bond. You recoup your principal faster and can re-invest in similar bonds that are paying a higher coupon rate.

Coupon Rate

The coupon rate is important because if you have two bonds that are identical, with the exception of their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with the lower coupon rate.  It will be affected less by higher interest rates than the lower coupon bond.

In order to help you understand the overall effect rising interest rates will have on certain bond prices, time to maturity, coupon rate, and a few other factors have been rolled up into one concept called Duration.

Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s cash flows.  The higher duration, the higher sensitivity a bond has to increasing interest rates.  As a general rule, for every 1% increase in interest rates, a bond’s price will drop by 1% for every year of duration.

For example, assume you own a bond fund that has a 7-year duration.  If interest rates rise by 1%, you can expect the price of your bond fund to drop by roughly 7%.

However, duration works in the opposite direction as well.  If interest rates were to drop by 1%, the price of your bond would increase by 7%.

So, what does this mean for your portfolio?

Managing Bonds In Your Portfolio

Back in 2013 I remember being at a conference and listening to a presentation given by a financial advisor of a large firm who was adamant that any financial advisor who had their clients invested in bonds was committing an egregious error.  His simple explanation was, “interest rates have nowhere to go but up, which means bond prices have nowhere to go but down.”  This advisor had eliminated the bond asset class from his client’s portfolios entirely and had replaced it with cash.

Since we understand the Federal Reserve’s goal to raise rates it would seem like a no-brainer to just not invest in bonds, but it’s not that simple.  Since that presentation in 2013, the Barclays Aggregate Bond Index, which measures the general bond market in the United States has posted the following returns[2]:

2013:  -1.98%

2014:  6.00%

2015:  0.48%

2016:  2.41%

2017:  3.61%

At an average annual return of about 2%, bonds prices barely outpaced inflation, and so for this advisor and his clients, maybe the trade-off was worth it.  But it’s still important to note that a $1,000,000 portfolio held in a bond fund tracking the Barclays Aggregate Bond Index would have gained roughly $107,000 over the past 5 years.

The bottom line is that while we know the goal of the Federal Reserve is to raise interest rates, we also know that nothing is set in stone.  Over the past decade, many planned rate increases never happened simply because the economy or stock market wasn’t ready to handle an interest rate increase.  Currently, the economy is strong but volatility in the stock market has returned which is a very decisive factor in the Federal Reserve’s decision to raise rates.

In addition, bond prices, like stock prices, are affected by investor sentiment.  It’s possible that over the past 10 years, the anticipation of rising interest rates have been partially “baked” into the current prices of bonds.

And don’t forget, that one of the main reasons we hold bonds in our portfolios is to mitigate risk through owning a non-correlating asset to stocks, which comes into play when stocks periodically go through bear markets.

This leads to the conclusion that now more than ever your bond portfolio must be diversified.  Having a bond portfolio made up of bonds that differ in duration, maturity, coupon rate, quality, geographical location, and sectors will ensure you’re positioned for whatever the future holds.

[1] https://www.federalreserve.gov/monetarypolicy/openmarket.htm

[2] http://performance.morningstar.com/funds/etf/total-returns.action?t=AGG&region=USA&culture=en_US

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