The Rise of Interest Rates and Fall of Bond Prices

Conservative investors may feel safer leaning more toward fixed income investments as opposed to stocks, but there's risk there too should interest rates start to creep up.

The looming uncertainty inherent in the stock market and geopolitical uncertainty have many conservative investors leaning more toward fixed income investments as opposed to stocks.

However, investors still need to also realize that absent “market-related” risk there is also risk in the bond market should interest rates suddenly begin to creep up. This is more commonly referred to as “interest rates risk.” The question then becomes, what is my exposure to rising interest rates, and how can one anticipate or measure the impact rising interest rates would have on an investor’s fixed income portfolio?

First of all, bond prices are a function of several parameters some of which are: 1) the bond’s term to maturity; 2) the coupon interest rate; 3) the current yield in the marketplace; and 4) the credit quality of the note. Without going into too much of the mechanics, permit me to go through an illustration of the impact of rising interest rates and how they impact bond prices.

Suppose the ABC Healthcare Corporation issued 30-year fixed rate notes two years ago and the coupon interest rate on those notes was 6.25%. Suppose further that the notes are BBB— (lowest investment grade) rated by Standard & Poor’s, and the current yield on notes being issued today in a similar risk class has climbed from 6.25% to 6.75%.

When you purchased these notes the issuer (ABC) promises to pay you $62.50 annually or $31.75 semiannually. When you purchased these notes you purchased them for their face value, or par value, of $1,000. Now, because interest rates have risen in the marketplace, these notes will have a value less than $1,000. Keep in mind that, in lieu of default, you will still continue to receive $62.50 annually or $31.75 semiannually regardless of what interest rates do from now through the time the note matures.

However, because interest rates have risen, you can now purchase a similar note today for $1,000 yielding 6.75% and receive more interest annually than the note you purchased two years ago! Therefore, the note you purchased two years ago will no longer sell for $1,000 but will sell at a discount to its face value. How much less? Almost $63! In other words, you purchased an instrument for $1,000 two years ago, received interest totaling $125 over that two-year holding period, and if you decided to dispose of the note today, you’d receive about $937 for a note that has a par value of $1,000 at maturity!

Not a great return on your investment especially when you have to consider that you will have paid income taxes on the interest received if the notes are held in a taxable account! And, of course the converse would also be true — had interest rates dropped the note would have increased in value. But falling interest rates are not something I would count on anytime soon.

Let us consider another instance. Suppose instead of having 28 years remaining until the note matures, there were only five years remaining until maturity. All other parameters are the same — the coupon interest rate is 6.25%, the current yield is 6.75% and the credit quality is BBB-. In this instance the note would worth $979 instead of $937! What can be inferred from this is that the shorter the time remaining until maturity, all other things being equal, the less volatile the note’s price will be for a given change in interest rates up or down.

BondsLaddering

Therefore, if considering a bond portfolio for a stable stream of income, try to shorten the duration and term to maturity of the bond to protect yourself from the impact of rising interest rates. This is one of the reasons why fixed income investors “ladder” their bond portfolios! In other words, purchase individual bonds with varying maturities that are of investment grade quality or better in order to minimize the chance of default.

Now a word of caution! If you are seeking to invest in individual bonds and you are seeking to do so with less than say $100,000, you are going to be hard pressed to construct a portfolio of bonds with varying maturity dates. The reason being is that in order to get competitive pricing on bonds, you generally have to deal in lots of $25,000 (25 notes) or more. Hence with $100,000 you will not get adequate diversification. Therefore, with a small amount to invest, mutual funds may prove the more viable alternative.

So, if individual bonds are not an option, next in the pecking order would be a diversified bond or fixed income fund. I went into the Morningstar database for the month ended Jan. 31, 2012 and conducted the following search as a benchmark for comparison.

I performed a filter of all fixed income (bond) mutual funds that had the following investment criteria: 1) all funds had to be at least average investment grade quality or better — i.e., BBB- or better; 2) only domestic U.S. bond funds — no world, international or emerging market bond funds were considered; 3) all funds in question had to have NO front end and/or back end loads; 4) all funds are taxable funds and municipal funds were not considered; 5) all funds had to have at least a 10-year track record; and 6) the minimum initial purchase had to be no more than $50,000. This sort yielded a universe of 726 funds.

The search yielded the following results. The “average” fund had a 12-month yield of approximately 2.9%. The average fund had an effective maturity of 6.4 years, and a duration of almost four years. The average 12-month, three-year, five-year and 10-year annualized returns were 6.5%, 7.5%, 5.5% and 4.8%, respectively. The average weighted coupon was 4.2% and average expense ratio was .77%!

Just to clarify bond duration, simply put, if the duration is four years, for a one percentage change in interest rates either up or down, the average change in value of the fund is approximately 4%! Also, an average coupon of 4.2% would mean that for every $1,000 of “par or face value,” the average annual interest paid is $42! Again, also keep in mind that income taxes would have to be pain on interest income earned if the fund is not held in a tax-deferred account.

You can see that going the mutual fund route would incur additional annual expenses of .77%. However, depending on your level of sophistication and the monies under consideration, mutual funds may be your only option for adequate diversification!

Let us consider another example. Based on a portfolio duration of four years, should rates increase by 1% or 100 basis points, the value of the underlying portfolio would decline by about 4%! So, in a worst case scenario, if there was $1 million invested in such a portfolio, a 6% yield or $60,000 in income would be partially offset by a $40,000 decline in the value of the portfolio. In this case the investor would still be ahead of the game by some $20,000 or by 2%.

Additionally, if interest rates were to decline, there may be some capital appreciation realized on the portfolio, but chances are this would not occur in the current economic environment as interest rates are already at record lows.

Odds are that interest rates will remain low for the foreseeable future until the economy is on solid footing. This will not occur over night. Therefore, it is important, when selecting fixed income investments, to focus on the credit quality, duration, maturity, coupon, yield, and diversification of the investments within the portfolio!

Thomas R. Kosky is a principal of the Asset Planning Group, Inc., in Coral Gables, Fla. The company specializes in investment, retirement and estate planning. In addition, Tom has also taught graduate level corporate finance in the Executive & Health Care Executive MBA Programs at the University of Miami in Coral Gables, Fla., for more than 20 years. Mr. Kosky welcomes your inquiries and comments. He may be reached directly at (305) 666-5198 or via email at TRKosky@aol.com.

Thomas R. Kosky was a regular contributor to PMD from 1995 to 2007 as the Finance Professor and he is will once again be writing on a regular basis on subjects relating to finance, investments, retirement, estate and asset protection planning to the readership.

He welcomes comments and/or suggestions for future topics!

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