Over the last month, bond yields have begun to climb. As the economy continues to recover, we expect the Federal Reserve will eventually take a more hawkish stance and slowly begin to raise interest rates. While an increase in the federal funds rate may still be up to a year away, we think it behooves investors to be mindful of the growing potential for rising interest rates and thus rising bond yields. Rising bond yields, in turn, mean falling bond prices as the two variables have an inverse relationship.
Particularly in this type of environment, we keep a close eye on bond duration. Bond duration is the calculation of an investment’s price sensitivity to a change in interest rates. Duration is expressed in a number of years. Although determining duration is a somewhat complicated calculation involving present value, yields, final maturity, call provisions, and sinking funds, there is good news in that bond and bond fund duration is a standard calculation. Duration is provided in the presentation of comprehensive bond and bond mutual fund information. Some digging may be required, but duration is disclosed.
Because rising interest rates mean falling bond prices and declining interest rates mean rising bond prices, it is in today’s environment that duration is most dangerous in terms of risk of capital. The Federal Reserve brought interest rates to very low levels and then has kept them at low levels for four years. At some point in the future, the Fed will stop artificially depressing interest rates and they will begin to rise. When this happens, bonds of longer duration years will begin to lose value. Institutional holders of long duration bonds will quickly unload their bonds, which in turn, will cause rates to rise even faster. Bonds of long duration (40 years) and intermediate-term bonds (9-25 year durations) potentially could lose a large portion of their investment value in a relatively short amount of time.
In anticipation of rising rates in the next couple of years, bonds and bond mutual funds should be carefully analyzed for their duration characteristics. Investments of medium and long duration should be removed or replaced before rates begin to rise, so as to preserve portfolio assets. Proceeds could be used to purchase short duration (1-7 year duration bonds and bond funds).
While we monitor the duration features of the bonds and bond funds we have in our clients’ managed accounts, you may have fixed-income assets outside of your managed assets with us. If you are in this position, please do not hesitate to contact your investment advisor here. We are happy to review the duration of these fixed-income assets and to make recommendations as may be appropriate. Similarly, if you would like to review the fixed-income portfolio you have with us please contact your investment advisor.