The Basics of Interest Rate Risk

Unlike with individual stocks, whose values can soar or plunge depending on the latest headlines, the payoffs from investing in bonds tend to be more predictable. Most bonds offer a set of periodic interest payments, with the initial principal returned when the bond matures. But that doesn’t mean that bonds—even bonds issued by the US government—are risk-free. Since (for typical bonds) the payments are set in stone when the bond is first issued, changes in interest rates can dramatically affect how much these payments are worth.

Because the future payments on a bond aren’t altered when interest rates on other investments change, a rise in interest rates causes the value of these payments (and therefore the price of the bond) to decrease. But by how much will the price fall? Fortunately there’s a number that answers that question. A statistic called “duration” is a rough estimate of how much the price of a bond will change (as a percentage) if interest rates move by one percentage point.

One of the key factors that determines the duration of a bond is the amount of time until the bond matures. Since there’s more time over which a change in interest rates can affect the value of longer-term bonds compared to shorter-term bonds, a rise in interest rates will tend to hit longer-term bonds harder. For example, the duration for the Vanguard Short-Term Bond ETF is 2.7 while the duration for the Vanguard Long-Term Bond ETF is 14.2. In other words, the effect of a change in interest rates will be about 5 times greater for the long-term bond fund.

For investors concerned about rising interest rates hurting their bond holdings, this difference reveals a simple way to reduce interest rate risk. Shifting part of a bond portfolio toward shorter-term bonds can make it much less sensitive to changes in interest rates.

Checking in on Abenomics

Shinzo Abe

When Shinzo Abe was elected as Japan’s Prime Minister in December 2012, he launched a bold plan of economic reforms that became known as “Abenomics”. These reforms included increased government spending, more purchases of government bonds by the country’s central bank, deregulation, and new international trade agreements. The aim was to jolt the country out of two decades of stagnation that had been characterized by deflation and mediocre economic growth.

Almost a year and a half into the implementation of this reform agenda, Abenomics appears to have made some progress. The value of the Yen, the country’s currency, has fallen by more than 20% since November 2012, helping Japanese exporters become more internationally competitive. The stock market has soared by 60% against the US dollar over the same time period (although for US investors some of that gain has been offset by the decline in the value of the Yen). Japanese wages rose in February for the first time in almost 2 years, suggesting that the quest to end deflation may finally be bearing fruit.

That doesn’t mean that Abenomics has been unequivocally successful. Many of Abe’s proposed regulatory reforms, such as breaking up the country’s electricity monopolies and loosening rules about how companies hire and fire workers, have struggled to gain support.  Some critics, such as economist Edward Hugh, argue that Abe’s attempts to stimulate the economy will ultimately fail.

The mixed outlook is reflected in the gyrations of Japan’s stock market: the overall rise since Abe’s election masks a few large drops, including a decline of more than 10% so far this year. Despite some early signs of success, the jury is still out on whether Abenomics will resuscitate Japan’s economy.

The Danger of Company Stock in 401(k) Accounts

Enron

When you’re thinking about how to select investments in your 401(k) account, there are often many options to choose from. Most of these are diversified mutual funds that each contain hundreds or thousands of stocks or bonds (or sometimes both). Many companies, however, also include a much less diversified investment option in their 401(k) plans: stock in the company itself. It’s an investment option that’s best avoided.

Lots of people (though certainly not everyone) like company they work for, so it may feel good to invest in your employer. This can be especially true when the company is doing well, since both the price of the stock and your income from your job are more likely to rise. But if the company starts doing poorly, the stock price and your income could decline at the same time, hurting both your paycheck and your portfolio. In other words, owning stock in the company you work for reduces the diversification of your wealth.

A classic example of this situation was Enron, the energy company that went bankrupt in 2001. Enron employees held nearly 60% of their retirement assets in company stock, which was wiped out as the company collapsed. Thousands of employees, many unaware of the risk they were taking, lost both their job and their retirement savings.

Enron is an extreme example: few companies will collapse in such spectacular fashion, and only having a small portion of your 401(k) in company stock isn’t likely to devastate your portfolio. Still, as a rule of thumb, it’s better to avoid such concentrated investments, especially when their performance may be connected to your income from your job.

Are Treasury Bonds “Risk-Free”?

Savings Bond

The term “risk-free” is often used to describe treasury bonds issued by the US government. Yet in recent years Congress has repeatedly hesitated to raise the legal limit on the amount that the federal government is allowed to borrow, sparking panicked legislative deal-making to keep the government from defaulting on some of its debt. After one of these episodes, in 2011, Standard & Poor’s even lowered its credit rating for the US government. After this political buffoonery, should you still consider treasury bonds to be riskless? The answer is that from an investors’ perspective, treasury bonds were never risk-free.

This conclusion is actually unrelated to Congress, the debt ceiling, or the amount of debt the government has already incurred. With one of the world’s wealthiest populations, well-functioning government institutions (at least compared to many other countries), and its own currency (unlike the debt-troubled countries of the euro zone), it’s extremely unlikely that the US government would be forced to default on its debt. Political posturing notwithstanding, treasuries are still essentially risk-free when it comes to the risk of default.

Yet there are other risks for bond investors aside from a default. There’s inflation risk: since treasuries typically have fixed payments (the size of the periodic coupon payments is determined when the bond is first issued), an increase in the inflation rate will make these payments worth less. And there’s interest rate risk: if interest rates across the economy rise, the value of the bond will fall since other investments will offer higher returns.

Compared to many other types of investments these risks are fairly small. Last May and June, for example, as interest rates surged, US government bonds overall lost about 3% of their value (longer-term treasuries, which are more sensitive to changes in interest rates than shorter-term ones, lost about 10% of their value). Stocks, on the other hand, routinely gain or lose more than 3%, occasionally even in a single day. Still, a small amount of risk shouldn’t be confused with completely risk-free.