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Interest Rate Risk and Duration

Hoover Financial AdvisorsDecember 8, 2016

Investments

Recently, a client expressed their concern about a rising interest rate environment and asked, “What exactly is bond duration and how are my bond holdings affected by interest rate changes?”

With Federal Reserve potentially (and I use that word loosely) raising interest rates in December and the recent sell-off in the bond market following Donald Trump’s presidential election win, it is hard to turn on the news without hearing about the risks facing investors who currently own bonds or bond funds. I thought an overview of bond duration and interest rate risk would be useful for our clients.

One of the most basic relationships in finance is that bond prices and interest rates exhibit an inverse relationship. Values of existing bonds go down as interest rates rise and go up as interest rates fall. While this may seem counterintuitive for some, a simplified example should help clarify this relationship. Suppose you invest $100,000 in a bond maturing in 10 years that pays a 5% annual interest payment. If interest rates on ten year bonds then rise to 6%, would you be able to sell your bond for its face value of $100,000? No. A possible buyer for your bond would not pay face value for your bond when they could invest their money in the newly issued 10 year bonds paying 6% per year. Conversely, the value of your bond will go down to offset the lower interest rate and provide the buyer with the prevailing interest rate available in the market. The opposite is true and your bond price will rise if new bonds are issued at a lower interest rate.

The extent to which a bond’s price fluctuates due to changing interest rates is called its volatility. This volatility depends on its coupon rate (or interest payment) and when it will be retired (or maturity date). All else equal, the general rule is that the longer time until maturity and the lower the coupon rate, the greater the price volatility. Therefore, if two bonds have the same maturity date, the one with the lower coupon rate will be more volatile and if two bonds have the same coupon rate, the one with the longer maturity will be more volatile.  

In a rising interest rate environment portrayed in this simple example, an investor wants their money returned as quickly as possible so that it can be reinvested at the higher 6% interest rate. Even though the bond matures in 10 years, they will begin to receive interest payments that can in theory be reinvested immediately at this higher interest rate. This concept is described as duration.

Bond duration can be defined as the measurement, in years, of the time it takes for the price of a bond to be repaid by its internal cash flows of interest payments and return of principal upon maturity. It is important to remember a few general rules of thumb with regards to duration:

  • Duration is always less than a bond’s remaining years to maturity. The larger the interest payment a bond pays, the shorter the duration as an investor is returned more of their money faster for reinvestment and vice versa.
  • In theory, for every 1% increase (decrease) in interest rates, a bond or bond fund will fall (rise) in value by a percentage equal to its duration. For example, a bond with a duration of 3 years will fall 3% for every 1% rise in interest rates and rise 3% for every 1% decline in interest rates.
  • Duration increases the further out the bond’s maturity date is from today. Short term bonds (maturing in less than one year) have the lowest duration and long term bonds (maturing in 30 years or more) have the highest duration.

Over the past few weeks, we have seen a large upward move in interest rates as investors have been selling bonds following Donald Trump’s victory and pricing in his possible fiscal stimulus policies, namely corporate and individual tax cuts along with increased infrastructure spending. This move in interest rates is purely reactionary to possible future actions from the new administration. The Federal Reserve is also expected to raise interest rates, albeit very modestly and gradually, starting in December. We believe the bond market has already priced in the anticipated rate hike in December, possibly calming some of the current volatility in bond prices. Historically, while rising interest rates may cause short-term volatility in bond holdings, interest payments (coupon yield) are a much more significant contributor to portfolio returns than price fluctuations from interest rate changes. Increasing interest rates actually allow us and our fund managers to reinvest money at higher coupon rates which helps offset short-term losses.

At HFA, we conduct in-depth analysis and due diligence when selecting the bond funds we use in our clients’ portfolios.  We do not make bets on long versus short duration as we believe getting the direction of interest rates right is every bit as difficult as predicting the direction of the stock market, which as you may know, is all but impossible. Over the past 8 years, many of the smartest minds in the industry have urged investors to keep duration low by holding short term bonds and in turn have missed out on the lion’s share of gains this asset class has to offer from longer term bonds. We prefer to hold a diversified mix of bond funds with varying duration and maturities to help manage risk and participate in gains across the entire yield curve. Our fund managers have the ability and expertise to buy and sell bonds on a daily basis to manage the duration of their bond funds based on their interest rate outlook. Our unique combination of bond funds focusing on different areas within the bond market helps allow us to weather the impact of changing interest rates.

Daily price fluctuations you may see in your individual bond holdings are simply the result of our custodian’s mark-to-market process. In other words, at the end of each trading day, our custodian must assign a market value to every bond as if it were going to be sold. Any losses shown from this process are only “paper losses” and are not actually realized. We encourage our clients to hold their individual bonds for the long term and until maturity where they are paid back the full face value of the bond and enjoy the interest payments along the way. Losses only become real when a bond is sold prior to its maturity date.

It is important to remember that duration is only one measure of fixed income risk and is not a complete measure of bond or bond fund risk. Duration does not tell you anything about the credit quality or default risk of the company issuing the bonds or the risk that a bond will be called (retired) by its issuer should it contain a call provision.

If you would like to learn more about bond characteristics or have any questions regarding your fixed income investments with us, please contact our office (610-651-2777) and a member of our investment department would be happy to discuss them with you!