Thursday, October 31, 2013

Interest Rate Risk in Bonds

For years now, investors have only considered credit risk, and not interest rate risk, in their bond portfolios. In addition to municipal defaults and deteriorating credit situations at large corporations, one now needs to ask about bond volatility. Questions such as "What happens to the value of my bond portfolio if interest rates rise 1%" should be as common as the usual credit questions.

Why do bonds fall in price when interest rates rise? Rather than get into the math behind the question, let's look at what is probably a more intuitive example:

Let's say that a couple years ago, you bought a new issue bond due in 2028 at 5%.
Let's move ahead to today. Let's say that same company is offering a new bond due in 2028 at 6%. In other words, rates have gone up.

Which bond would you rather own? Same company, same bond, same maturity. You would, of course, rather own the 6% bond. Another way of saying this is "The 6% bond is worth more to me than the 5% bond."

That's it in a nutshell. When rates move higher, bond prices fall. People will pay a little less for a lower coupon bond than a higher coupon bond.

How much bonds change in price gets into math that I don't want to cover here. A good rule of thumb is that a 1% rise in interest rates will cause your bond portfolio to fall in price in an amount roughly equal to its average maturity. So, an 8 year average maturity bond portfolio might be expected to fall 8% with a 1% rise in rates.

There are ways for bond portfolio managers to actually lessen volatility while keeping maturity the same. To read more about this, go here.

Don't ignore your bond portfolio. Today's retirees most likely have at least 40% of their portfolio in bonds and that is too much money to leave to chance. It needs to be tended to with the same care that the equity portion of your portfolio has received.