Prepare for rising interest rates
The bond market has enjoyed over two decades of general prosperity. Since 1981, interest rates on long-term bonds have trended downward from 15% to 5%.(1) Investors have swarmed to stable-return investments since the bear market in stocks began in 2000. As a result, bond managers have trounced stock managers by an average five percentage points per year. A three-year bond winning streak is a rare event in market history, having last occurred from 1939 to 1941.(2)
The winds could be shifting soon. Interest rates are at a 40-year low. The Iraq War is essentially won. The economy is poised for a turnaround. The government is now running a budget deficit. These and other indicators point to a higher demand for credit, rising interest rates and falling bond returns in the near future.
Holding a fixed income component in your portfolio is a prudent strategy. If properly selected, bonds can enhance diversification and provide a steady interest payment stream that may reduce overall volatility while boosting total return. But many investors are herding to fixed income for less credible reasons. They are fleeing the bear market in stocks and are assuming that the bond market boom will continue.
Economic forces are working against continuing bond gains. Bond managers are warning of a current oversupply and rising volatility within the fixed income class. They also claim that investors are fueling a bond market bubble with a reckless abandon resembling the stock mania of the late-1990s.(3) We know how that story ended—and it’s worth avoiding.
Historically, interest rates climb when the economy enters a rebound. Rising business and consumer activity raises the demand for money and credit. The bond market views economic revival as indicative of higher inflation, which creates worries over the erosion of principal. And at some point, the Federal Reserve will raise interest rates to prevent the economy from overheating.
Now consider how changing interest rates affect bond values. There’s an inverse relationship between current interest rates and bond market prices. When interest rates fall, the value of an existing bond rises because investors are willing to pay more to obtain the older, higher rate. When rates increase, bond values fall since investors can get the new, higher rate from a new bond. The bond’s resulting price drop in the secondary market is necessary to make its current yield competitive with a new debt issue of comparable quality. Bond price movement depends on several defining attributes, including maturity, duration, coupon rate and credit quality. (These are explained below in Factors Influencing a Bond’s Market Price.) Interest rate changes affect some bonds more drastically than other debt. For instance, bonds with a lower coupon rate, a longer maturity and higher credit rating tend to be more interest sensitive. On the other end of the spectrum, high-yield bonds— or junk bonds—are the least rate sensitive due to their high coupon rate, typically shorter maturity, low credit rating and dependence on economic performance.(4)
Forecasting an economic rebound is a hard task. But rising rates will inevitably follow a strong and sustained upswing. With this in mind, you should consider how a new business cycle could affect the fixed income component of your wealth.
This begins with a review of interest rate exposure in your portfolio. Have declining stock values changed the balance of your equity/bond mix? Are you holding longer-term bonds that are showing sizable price gains? If so, you might sell a portion and use the proceeds to resupply your stock allocation and acquire bonds of shorter durations. Also examine the quantity and credit quality of bonds with an eye on diversification. If you are holding individual bonds, consider a laddering strategy to spread out maturities. If you can afford the extra risk, you might consider moving down the credit spectrum for higher yield.
Risk tolerance and time horizon should frame the decisions regarding asset allocation, income structure and bond diversification. Modern Portfolio Theory views the fixed income asset group as a tool for reducing volatility. Bond performance matters. But a portfolio’s total return should be the final measure of success. This keeps investors focused on the right things.
Factors influencing a bond’s market price
When interest rates move, the adjustment in a bond’s market price depends mostly on these factors:
Coupon Rate: This is the bond’s stated interest to be paid over the term. Lower-coupon bonds are more sensitive to changing interest rates. This is because a one-point (1%) move in the current rate is a larger proportion of a lower-coupon bond. The lower the coupon interest, the larger is the market price adjustment.
Maturity: The longer a bond’s maturity, the more a rate change will move its price. In theory, issuers offer a higher coupon rate on longer-term debt to compensate for added uncertainty, as demonstrated by a normal yield curve. But this is not always the case. When the yield curve is flat or slopes downward, lenders are not compensated for the higher risk of longer maturities.
Duration: Duration states the years until your full investment is returned, taking into account cumulative interest payments and principal repayment. Duration provides a measure of a bond’s sensitivity to interest rate changes. A one-point interest rate move alters a bond’s market price by its approximate duration. Thus, a five-year duration bond will gain/lose about 5% in market value for every one-point change in interest rates.
Credit Quality: Issuers perceived to have lower default risk (e.g., a higher credit rating) can offer a lower coupon rate. But the lower rate makes them more sensitive to shifting market interest rates. On the other end of the spectrum, high-yield corporate bonds (junk bonds) respond little to rate shifts, but are highly sensitive to economic factors and credit rating adjustments.
(1) “That’s All, Folks”, Forbes, 20 Jan. 2003, p 106
(2) “The Coupon Clipper”, Worth, March 2003, p 49
(3) “A Little Late to the Party”, Fortune, 20 Jan. 2003, pp 176-78
(4) High-yield bonds carry substantial risk of default, however, since they have the lowest credit rating. Investors should limit their exposure to these securities and diversify extensively to reduce the effects of a high default rate.