Change is in the air. Last month the Bank of Japan (BoJ) introduced a novel plan to target the 10-year Japanese government bond yield, shifting its focus from bond purchases to a long-term rate peg. Stateside, the Federal Reserve (Fed) again left the federal funds rate unchanged, but the probability of a December rate hike is climbing. Global interest rates are likely to rise—or at least fluctuate—after being kept extraordinarily low in the years since the financial crisis.
Although yields are ultralow—the 10-year U.S. Treasury yield is currently around 1.60%—the duration, or interest rate sensitivity, of bond investments has steadily risen (source: Bloomberg). What that means: Even a small rise in rates will likely have a big impact on some bond segments. With duration in mind, which bond segments should investors consider in a potentially rising interest rate environment?
What is duration?
Some fundamentals first. When interest rates fluctuate, bond prices generally shift. Rising rates typically push bond prices lower, while falling rates push bond prices higher. Duration, expressed in years, measures a bond’s interest rate sensitivity. The higher the duration, the more the bond’s price will change when interest rates move, therefore the higher the interest rate risk.
An example: For a bond with a duration of 10 years, it could appreciate 10% in price if interest rates fall by 1%. Should interest rates rise by 1%, the bond could fall 10%. For a bond with a duration of two years, it could appreciate 2% in price if interest rates fall by 1%. The same bond could fall 2% should interest rates rise by 1%.
When we say “short duration,” we are generally referring to bonds that mature within three years. Short duration bond strategies have historically had lower yields than long duration bond strategies, but when interest rates rise, short duration strategies may experience a smaller price drop.
This refers to bond funds with average maturities of 3 to 10 years. Usually, yield is higher with these types of bond strategies than with short duration, while interest rate risk is lower than long duration.
This generally points to bond strategies with an average maturity of more than 10 years. This strategy usually offers the highest interest rates, which can be optimal in a falling rate environment. But when rates rise, long duration bond strategies can experience sharp price declines.
What to consider, the long and short of it
Generally, when investors believe interest rates are going to increase, they typically shift to a lower duration strategy to potentially reduce the interest rate risk in their portfolios. This is more likely to occur if they hold higher duration bonds. The price of a high duration bond will likely fall more than the price of a low duration bond when rates rise.
This strategy gets a little more complicated when we look more closely and differentiate between different interest rates. A hike in the fed funds rate increases short-term rates, but does not necessarily impact medium- and long-term rates. Even if the Fed does move as expected in December, the impact on the overall bond market may be muted.
So what to do? Know that interest rate sensitivity is currently high, and that a movement by the Fed could push short-term rates up. But don’t be spooked by what the Fed may do. Think closely about the role that fixed income plays in your portfolio.
If, like many investors, you have a long time horizon and you look to bonds for equity diversification and income, then there isn’t necessarily any action to take. Be informed and know what is going on with your portfolio, but also keep the long-term view front and center. Making significant short-term portfolio shifts could compromise your long-term investment goals. In investing, patience is key.
Investing involves risk, including possible loss of principal.
Fixed income risks include interest-rate and credit risk. Historically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
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