By Miles Clyne
After years of historically low interest rates, some governments like the US seem intent on raising them. As much as this is disturbing to many, it is a necessity. What investors need to face up to are the consequences of what hanging onto a traditional bond portfolio might be.
The Two Key Drivers of Bond Returns: Interest Rates and Credit Quality
Interest rates directly impact the price of all bonds. Rising interest rates tend to lower the price of bonds, and the longer the bond has until it matures the greater the decline in its price. IE: a bond that matures in 10 years would drop more than a bond maturing in 5 years, all things being equal.
Credit quality of a bond issuer is critical. The greater the credit risk, the greater the potential for profit or loss. Here is an interesting tidbit. High yield bonds used to be called Junk bonds. Any idea why the name changed? My thought is marketing. Would you buy a junk bond or a high yield bond?
With interest rates so low, investors in every type of bond should be very wary if interest rates start to climb. Another interesting tidbit: the bond market is smarter than you or I; by the time you know for certain rates are climbing, the price of your bond will already have adjusted. This means you will have either made or lost money depending on what direction interest rates moved.
Here is a rough example of what rising rates could do to a bond’s price. Take a $100,000 bond with a relatively short duration of 4 years – note that duration is a measure of a bond’s sensitivity to interest rate changes A low number (short duration) is less sensitive to rates, while a high number (long duration) is more sensitive. For every 1% interest rates move, the price of this bond could move approximately $4,000 up or down, depending upon the direction interest rates moved. Remember, rising interests rates typically convert to losses on most traditional bonds.
Why Own Bonds?
That is a great question, thanks for asking. Typically, bonds are far safer in terms of how much they can fall relative to equities in your portfolio, even in a rising interest rate environment. They are the insurance in your portfolio. If the equity market goes through a severe correction, bonds may rally. I’d suggest that would be an opportune time to sell some of your bonds and average down on the price of your equities. Other than that, with rates so low, I’m challenged to find another reason.
When interest rates get back to a normal level, bonds could get back to being a prudent source of income for investors. This is the necessity I spoke about in the opening paragraph. People who depend on a quality, safe source of income don’t have that anymore with most bonds. Until then, be very cautious and get good advice on your bond strategy.