David Peartree, BridgeTower Media Newswire
The era of rising rates may be upon us, or not. Time will tell, but it's clear at least that interest rates have been on the rise since the second half of 2016 and especially since the election. The yield on the 10-year Treasury rose by about .60% since the election. It is instructive, therefore, to revisit the hype regarding the impact rising interest rates may have on bond prices.
As rates have risen over recent months, bond prices have fallen. Investment grade bond prices, for example, fell by several percentage points after the election. That much is old ground; we know that bond prices generally fall as interest rates rise and, conversely, prices rise as interest rates fall.
How concerned should investors be about the impact that rising rates may have on their bond prices? Can we determine in advance what the impact will be? If so, what, if anything, should investors do with their bond allocations?
One tool at our disposal to assess the sensitivity of bonds to rising interest rates is a published measure called "duration." Never mind the jargon and the technical details behind the term, just think of duration as a measure of the sensitivity of bond prices to interest rate changes.
The expected loss from a rise in interest rates is simply a bond's duration times the interest rate increase. If, for example, a bond is assigned a duration of 5 and interest rates increase by 2% in one year, the expected loss is 10%.
The caveat is that duration is simply a model from which real prices can and often do diverge. As Morningstar said in a recent analysis, measuring the interest rate sensitivity of bonds is more an art than science. The limitations of using duration as a measure of interest rate sensitivity are several.
Duration is only an estimate. Duration is most accurate with respect to a single bond, but even then it is only an estimate. Market data has shown that bond prices don't always move up or down in line with estimates. Morningstar reports that even under normal market conditions, "a bond's price may not move exactly as its duration predicts."
It's less accurate for certain types of bonds. Duration estimates for individual bonds tend to be most accurate for the highest-quality bonds, such as Treasury bonds and investment grade corporate bonds. As bonds get more complicated, estimating interest rate sensitivity becomes less reliable. Examples include government agency mortgages that may be repaid early if rates fall or corporate bonds with a call option that may get triggered if rates fall.
It's less accurate for bond funds than for individual bonds. These days most individual investors hold bond funds rather than individual bonds. Estimating interest rate sensitivity for a collection of bonds is far more challenging than for a single bond. Even a fund that holds a single type of bond will contain a mix of maturities in various weights. Add in the variables of different credit qualities and different issuers and things get even trickier.
Two funds with the same reported duration values can perform differently in response to interest rate changes. That is the case, in part, because assigning duration values requires the application of human judgment about which reasonable people may differ.
Even advisers schooled in this subject can fall into the trap of assuming a degree of certainty and precision that is not merited. That may be because we give undue deference to information presented in the form of math. Investment principles, however, are not like fixed laws of math or science.
There are several instructive points for investors. The first is a general point: We should not rely blindly on any single portfolio statistic. Portfolio statistics may be presented as a mathematical statement, but they are built on a set of assumptions - a human input - that won't always match reality.
The second point is that our ability to estimate how bond prices will change in response to rising (or falling) interest rates, though imperfect, is still useful if the limitations of those estimates are understood. Morningstar recently reported a surprising conclusion about how accurate those estimates are.
Morningstar concluded that most bond categories "will lose less money than their duration numbers suggest." In other words, most bond funds appear to have overstated the interest rate sensitivity of the fund. The impact of rising rates on bond fund prices may be less dire than has been suggested.
Investors should be aware of the risk that rising interest rates presents to the price of bonds in their own portfolio, but they should not be unduly alarmed. For investors with a well-balanced, diversified bond portfolio, it's quite likely that they should get ready for rising interest rates by doing absolutely nothing.
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David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625, david@worthconsidering.com.
Published: Fri, Jan 20, 2017
