Fixed Income Investing in a Rising Rate Environment
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For the greater part of the last 30 years, declining interest rates have boosted total returns on fixed income and provided a tailwind to bond investors. In 2012, interest rates touched a modern era low with the 10 year Treasury rate declining to 1.38%1. Recently, the decline has been the result of Federal Reserve monetary policy directed to keep longer term interest rates low until a broad economic recovery takes hold. Longer term, the decline has been the result of multiple pressures – an inflation rate which declined from a peak in the late 70s to a low stable level, a slower growth environment, and the globalization of finance which has resulted in national and even global competition for loan issuance.
With interest rates at historic lows, investors are becoming more concerned about what a rise in interest rates may mean for their portfolios. What would rising interest rates mean for bonds?
Interest Rate Risk
Bond prices are inversely related to interest rate changes. That means, as interest rates fall, bond prices increase. As interest rates rise, bond prices decrease. This price fluctuation which results from interest rate movement is known as interest rate risk. A simple example illustrates how this works:
Assume the interest rate is 4% when Company A issues a two year bond which pays 4% annually. At the end of the first year, interest rates have moved up to 5%. Company B then issues a one year bond which will pay 5% over the next year.
An investor has the option to purchase Company A or Company B's bond. Both have one year left until the bonds mature. In the example below, the maturity value is the par value of the bond plus the annual coupon payment received at maturity.
| Par | Interest | Maturity | Maturity Value | |
|---|---|---|---|---|
| Company A | $1,000 | 4% | 1 Year | $1,040 |
| Company B | $1,000 | 5% | 1 Year | $1,050 |
Because Company A's bond will pay less interest over the next year than Company B's bond, it should be worth less to investors. In fact, the market value of Company A's bond will fall to roughly $990 so that an investor can purchase either bond A at a price of $990, or Bond B at a price of $1,000, and earn the same rate of return.
| Purchase Price | Maturity Value | 1-Year Return | |
|---|---|---|---|
| Company A | $990 | $1,040 | 5% ($1,040/990) |
| Company B | $1,000 | $1,050 | 5% ($1,050/$1,000) |
In the case above interest rates increased and the market value of existing bonds decreased so that the return versus new issue bonds would be the same. If interest rates had declined, investors would be willing to pay more for existing bonds so that the return versus new issue bonds is again the same.
What does this mean for an investor's portfolio? A rising interest rate environment may cause a decrease in the value of existing bonds. The degree of the price movement will depend on the bond's duration.
Bond Duration
A bond's sensitivity to interest rate risk is called duration. A bond’s duration provides the approximate price change the bond would experience if interest rates moved by 1%2. As an example, assume a bond has a duration of 5 years. The interpretation implies that if interest rates increased by 1%, the value of the bond would fall by approximately 5%. Similarly, if interest rates decreased by 1%, the value of the bond would increase by approximately 5%.
Note that if a bond price falls after purchase, the market value will revert to par the closer the bond gets to maturity (provided there is no default by the issuer). Losses are only realized if the bond is sold prior to maturity. In addition, as bonds continue to pay coupons, the total value of the bond plus coupon payments is likely to exceed the purchase price well prior to maturity.
Summary
The fixed income environment may be challenging in the face of potentially rising interest rates. However, a diversified approach including traditional core fixed income, strategies designed to mitigate rising interest rates and strategies designed to avoid rising interest rates could offer a way forward. Contact your HD Vest Financial Advisor to review your current investment portfolio to analyze your current level of interest rate and duration risk.
