By: Richard Feldman, CFP®, MBA, AIF®
There has been tremendous talk in the financial media about the possibility of a bond bubble building in the fixed income markets. In response to the financial crisis of late 2008, investors have been trying to mitigate risk by moving assets into less risky investments. The Investment Company Institute reported that from January 2008 through June 2010, outflows from equity mutual funds totaled $232 billion while bond funds have seen $559 billion of inflows. Most investors view bonds and bond mutual funds as a safe haven often failing to realize that you can lose a lot of money in bonds particularly when you are investing funds into securities that are at historically low yields. Whereas a US Ten Year Treasury note yielded 3.97% in January 2008, it currently yields 2.80%.
It’s all about Duration
Most individuals know that bond prices fluctuate with interest rates and that longer maturity bonds tend to fluctuate more from changes in interest rates. However, most individuals are not familiar with the concept of duration. Duration is a weighted average of the times that interest payments and the final return of principal are received. The weights are the amounts of the payments discounted by the yield-to-maturity of the bond. The reason why duration is a better measure of volatility than average maturity is that duration takes into account differences in coupon rates. A 10 year bond with a 5% coupon will be more sensitive to interest rate swings than a 10 year bond with an 8% coupon. That is because the 8% bond pays the investor $80 per year which allows the investor to be repaid faster with the higher yielding bond than with the five year bond that pays the investor $50 per year (Assuming a $1,000 face amount).
Duration is the single most important measure of how risky most bonds are because it measures their sensitivity to interest rate changes. Duration tells you how a bond or a bond fund will react to a one-percentage point change in interest rates.
The formula to figure out how a change in interest rates will affect a bond fund is as follows:
Realized Gain/Loss = -Duration [Change in interest rates · 1 + Yield to Maturity]
For example: a bond has a Yield to Maturity of 7.5% and the bond has duration of 12.4 years. If interest rates rise 1% the investor would lose 11.53%. Change in Bond price = -12.4 (.01 Ã·1.075) = -11.53%.
In response to the financial crisis the Federal Reserve has embarked on a policy of holding short term interest rates at virtually zero while also purchasing mortgage backed securities and more recently US treasury securities in order to push interest rates lower. To follow is a chart of the 10 year treasury constant maturity (data taken from the St. Louis Federal Reserve).
As you can see from the chart above intermediate term rates have come down dramatically from the earlier part of the last decade.
The sensitivity of a bonds price to changes in market interest rates is influenced by three key factors: time to maturity, coupon rate, and yield to maturity.
- Holding time to maturity and yield to maturity constant, a bonds duration and interest rate sensitivity are higher when the coupon rate is lower.
- Holding the coupon rate constant, a bonds duration and interest rate sensitivity generally increase with time to maturity. Duration always increases with maturity for bonds selling at par or at a premium to par.
To shorten the duration of a bond portfolio you can purchase short term to intermediate term bonds that are selling at a premium to par. If you invest your fixed income assets through fixed income mutual funds select a fund with a duration of less than five years. That way if interest rates reverse course and rise you will limit your downside risk of the fixed income portfolio.
Fixed income investors face three types of risk: interest rate risk, default risk, and re-investment risk. Keeping the duration of your portfolio short will limit the risk of the loss of principle in your fixed income portfolio and allow your portfolio to adjust to higher rates quicker because the rate at which you reinvest the income from your portfolio will be higher. Over time, reinvestment of interest on your bonds at higher rates adds up, allowing you not only to offset your initial loss of principal but also to profit more than if rates had never moved at all.