Michael Schaab, CFA
Vice President, Portfolio Manager
Thomas Holloway, CFA
Fixed Income Analyst
Interest rates have been at historic lows for the past several years, in part due to the U.S. government’s bond-buying program designed to support the economy. Since U.S. Federal Reserve Chairman Ben Bernanke hinted in June that the Fed could soon end this support, there has been a selloff in bonds as investors anticipate higher rates.
However, what might be surprising is how rising interest rates will affect bond portfolios. A client recently asked if he was going to lose 20 per cent on his bond portfolio if interest rates increased. That sounds like a lot, but let’s see how reasonable that estimate might be.
If we assume rates increase by four per cent (an aggressive assumption, since we are currently expecting two-per-cent rate increases over the next few years), how would this affect a bond portfolio?
First, we need to consider the concept of “duration.” This is a complex calculation that includes the yield, final maturity and other features of the bond. The larger the duration number, the more sensitive the bond price will be to changes in interest rates.
Next, let’s use the DEX Universe Bond Index, a broad measure of Canadian investment-grade fixed-income instruments, to determine a theoretical drop in value of a bond portfolio. The index’s current duration is 6.8 years, so we could expect a 27.2-per-cent drop in the portfolio’s value. We arrive at this figure by multiplying the duration by the four-per-cent rate change. If we took an investment-grade corporate bond portfolio with a lower duration of 4.3 years, we would expect a drop in value of 17.2 per cent—still a significant decline. So the client’s question was reasonable.
However, the proper analysis isn’t as simple as forecasting how much rates will rise and multiplying that by the portfolio duration. Another important factor is how long it will take the rates to move up. Duration only measures the effect of a one-time change in interest rates. In reality, rates won’t move all at once; they will likely increase slowly over several years.
Bonds will continue to pay the “coupons,” or interest rate stated on the bond at issue time, while interest rates change. So depending on how long it takes for rates to rise, the capital loss on the bond portfolio will be offset by the income from the coupons. As well, in each quarter, the starting yield will be higher, offsetting the duration losses further.
Using the same DEX and corporate bond portfolios under a more realistic scenario, what happens if it takes four years for the rates to move up, say one per cent every year for four years? At the end of the four years of consistent rate increases, the DEX Universe Bond portfolio will have lost seven per cent total value (-1.75 per cent per year) and the corporate bond portfolio will have actually increased in value by two per cent. This is a big difference from the duration-computed returns we calculated earlier and demonstrates that although an environment of rising rates is not as good for bonds as a falling-rate environment, it may not be as bad as we first feared.
This isn’t to say that bonds are cheap today. They aren’t. But bonds still serve a purpose in an overall portfolio. Investment-grade bonds are one of the only asset classes that move in the opposite direction of equity markets in bad times. So bonds can provide liquidity and hold up the value of your overall portfolio when equity markets are sinking.
To guard your bond portfolio against rising interest rates, it is important to maintain a low duration, but keep in mind it is not only the amount of the rate increase but also how long it takes the increase to happen that will affect your bond returns. And, as always, your overall portfolio should include a balance of asset classes and investors should be patient, focusing on the long term rather than making decisions based on short-term events.
This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. All tax decisions should be made after discussing your individual positioning with a qualified tax accountant, as everyone’s tax situation is unique. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.