03 Dec 2013
- Written by Charles Sims Jr.
This is a question you could soon begin asking as a recent rise in interest rates contributed to price declines in many bond funds. News the Federal Reserve feels comfortable enough with the strength and state of our economy to consider a change in current monetary policy is, without doubt, a positive development. Unfortunately, for some bond investors, good news may be bad news!
Bond prices and yields have an inverse relationship, meaning they move in opposite directions. This means as yields (interest rates) rise, bond prices (values) can fall. Many investors – driven by fear, the need for income, increasing underweight allocations, or other factors – have invested heavily in bonds. Over the past five years, this demand has helped drive bond prices higher, lowering yields and subjecting many investors to the often ignored or forgotten risks associated with these investments, one of which is "interest rate risk".
"Interest rate risk" is a term used to describe how an investment's value will change due to an increase or decrease in interest rates. As a simple example: a bond yielding 4 percent is more valuable to investors if interest rates fall to 2 percent and is less valuable to investors if interest rates rise to 6 percent. This is because their fixed interest income would either be greater than or less than what a new investor would receive purchasing a bond at current rates. Interest rate risk affects all bondholders, but typically bonds with longer maturities and/or lower yields are most impacted.
One measure you can use to gauge how much interest rate risk your investment may have is "duration". Duration, measured in years, can be used to estimate a bond's price sensitivity to a move in interest rates. Fortunately for investors, duration is reported by most bond mutual funds & exchange traded funds (ETFs) and can be found by visiting the fund company's website.
So how do you apply this information?
The general rule is for every +/- 1 percent move in interest rates a bond's price will move inversely (opposite) by a percentage equal to that of its duration. As an example: assume a bond has a duration of 6 years and interest rates rise 1 percent, the effect would be a 6 percent decrease in the price of the bond. Under the same example, had rates fallen 1 percent the bond's price would have increased 6 percent.
Going forward, it is unlikely bonds will generate the returns many investors have grown accustomed to over the past few years. However, bonds are and will remain an important asset class because of the income and long-term diversification they provide. By using duration as a guide and having a conversation with a financial planner to discuss what impact rising rates may have on your portfolio, you can help reduce the chance of any unexpected surprises.