I recently gave a presentation on the current financial markets. During one part of the presentation, I mentioned how risky the bond market was in my opinion. The 10-year Treasury note was yielding 1 ½% at the time and bond prices move in the opposite direction of bond yields. How much lower could yields go from 1 ½%? There was very little upside potential for bond prices and a good bit of downside if interest rates rise. My audience was surprised by this comment since all of the firm’s clients have some portion of their investment portfolio invested in bonds. Was I planning a major change in our investment strategy?
Let’s begin by studying the chart I prepared to illustrate the relationship of bond prices to interest rate changes.
The column headed by 1.5% represents a new bond purchased today. The figure 100.00 is a percentage of face value. Therefore if you invested $10,000 in a bond yielding 1.5% and interest rates never change, the bond could be sold for $10,000 at any time. The column headed by 2.0% shows what would happen to the value of that bond if interest rates moved up ½%. A 10-year bond would drop by 4.51% in value. A 5-year bond would lose 2.37% of value. Longer maturities are more dramatically affected by interest rate changes. This is because your bond will mature at face value no matter what happens to interest rates as long as the issuer does not default.
The chart continues by showing the impact of a 1% interest rate increase and then a 1 ½% increase. The 10-year treasury yielded 3% as recently as mid-summer 2011. A new treasury would lose nearly 13% of market value if rates returned to those of just a year ago. Holding it to maturity would return the entire principal but you would have to endure several years of negative returns until enough interest accumulated to offset the drop in principal in the beginning.
This does not mean that we advocate avoiding bonds for any portion of an investment portfolio. Bonds play an important role in our investment strategy. We use bonds to stabilize principal and store a portion of the gains from the equity portion of the portfolio when the stock market is rising. This is accomplished through a fixed income technique called “laddering”. Laddering assures that a portion of the fixed income portfolio is maturing on a regular basis. Since bonds mature at face value the maturing bonds are not affected by rising interest rates. The proceeds of the matured bonds can be used to meet a client’s liquidity needs, buy equities if the stock market is down, or buy a new bond if the portfolio is already balanced.
Our fixed income portfolios have a maximum maturity of five years. Ideally, 20% of the fixed income portfolio will mature every 12 months. The average maturity would be about 3 years. The chart above indicates that we could expect our typical fixed income portfolio to drop by 1.45% during a ½% interest rate increase. This is a small enough decrease that it would be recovered by less than a year’s worth of interest earned by the bonds. A return to 3.5% would take longer to recover but it would be offset by an increasing yield on the overall portfolio as bonds are renewed at the higher interest rates.
Bond ladders are an efficient way to manage interest rate risk in a fixed income portfolio. Diversifying maturities addresses one part of the risk. Default risk is managed by monitoring credit ratings and diversifying issuers. We diversify by company and by industry. This would apply to building a tax-free bond portfolio as well. The issuers would be diversified by municipality and by types of bonds – i.e. school, water & sewer, airport authority, etc.
The risk to a bond portfolio can be managed if it is done properly. Interest rates may not go higher in the near term but there is very little room for them to go lower. You should be taking steps today to minimize the impact of higher interest rates on your fixed income holdings.
- Rising interest rates will cause the value of current bond positions to decline.
- Bonds mature at face value no matter what happens to interest rates as long as the issuer doesn’t default.
- “Laddering” a fixed income portfolio helps protect the value when interest rates rise because part of the portfolio matures on a regular basis.