Tuesday, February 8, 2011

Rising Rates and Falling Bonds

As higher interest rates have begun to appear, professional hand wringers, nervous Nellies, wet blankets, and killjoys have all come charging into the streets, arms waving and warning bells ringing. Higher interest rates means lower bond prices and the rush to exit the bond mutual fund arena has lately become a stampede.

Has anyone slowed down on their way to the exit doors and considered what the bonds of various maturities will do in a rising interest rate environment? Has there been any consideration given to the opportunity cost of selling a bond yielding 4% and moving into a money market fund paying 1/4%?

Let's take a look at two bonds: One is due in 2021, and one is due in 2041. Both bonds have 5% coupons. The ten year bond is yielding 3.38%, the 30 year bond is yielding 4.92%. Let's bump up interest rates on each bond 3% over the next 4 years. Voila! Come 2015, the 2021 bond is now down 14.2% in amortized value versus its purchase, and the 2041 bond is now down 32.8% in amortized value versus its purchase. If interest rates rise another 2% over the following three years, then in 2018 our 2021 bond would be down 12.7% in amortized value versus its purchase price and the 2041 bond would be down 44.8% in amortized value versus its purchase price.

Focusing on the 2021 bond: If one moves from 3.38% to money funds, the opportunity cost is approximately 3.25% each and every year. By the seventh year, that equates to a lost opportunity of almost 23%. Compare that to the 12.7% loss in principal value coupled with the 23.66% total coupon income received over those years for the bond holder. The bond holder's portfolio is ahead by almost 11% versus the nervous Nellie who went to money funds. 11% better on a portfolio is significant.

Pick your spots on the curve wisely. Yes, there is higher yield available in longer maturities, but there is significantly higher risk also. Before dismissing bonds altogether, quantify the risk of an interest rate change of 5% over the next 5 years or so. You may be pleasantly surprised.

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