Thursday, March 28, 2013

Bond Coupons and Price Changes

Here we are in one of the lowest interest rate periods in history, perhaps poised on the edge of a rising interest rate environment. Naturally, a question one might ask is "How much will my bonds fall in price when interest rates rise?"

Bond sensitivity, or the amount a bond changes in price according to an interest rate change, is referred to as "bond duration." Bond duration is tied to bond coupons and bond maturities. As complex as equations like this look:

 V = \sum_{i=1}^{n}PV_i

most investors with a bond portfolio or with a bond fund or bond ETF portfolio need to know only one thing: "What is the average duration of the bonds in my portfolio/fund/etf?"

Once an investor knows his or her average duration, that investor has the information to then answer questions like "What will happen to my portfolio if interest rates rise 1%?"

Let's take a look at an example:
Investor A has a $1mm bond portfolio (or bond fund or bond etf) with an average duration of 10 years. With a 1% rise in interest rates, that investor's portfolio would fall in price approximately 10%. So, a $1mm bond portfolio would fall to $900,000.

Here comes the tricky part: Let's say the investor needs the 5% yield that he or she can only get by going out 15 years in maturity. If that investor bought par bonds at 5% yield to maturity, that investor's duration would be around 15 years. However, if that investor bought 6% or 7% coupon bonds, still at a 5% yield to maturity, some interesting things happen.

First, in both cases that investor would receive a 5% yield to maturity. However, in a 1% interest rate rise, the investor buying par bonds might see a $150,000 price decline in his portfolio. On the other hand, the investor buying the 6% or 7% bonds might see only a $120,000 decline in his portfolio.

That's right. In both cases, the investor achieves a 5% yield to maturity but in the second case, the investor has a less sensitive bond portfolio and saves himself $30,000. This is the sort of thing a bond portfolio manager will work on all day long: how to structure a less sensitive bond portfolio when faced with the possibility of rising interest rates.

Watch your bond portfolio carefully. Does it have high coupon bonds? Low coupon bonds? Is the maturity longer than you need for the yield you need? Is your bond manager actively seeking less sensitive bonds? This could save you $20,000 or more in the next few years if we indeed move into a higher interest rate environment.

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