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Managing a Bond Portfolio During a Rising Rate Environment

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By Sterling E. Russell, CFA

There is a widely held view that, with the Federal Reserve raising interest rates and reducing its balance sheet by selling treasury bonds and mortgage-backed securities, bonds will be a drag on portfolio performance and should be avoided.  It is true that bonds prices are subject to movements in interest rates and the longer the maturity date of a bond the more sensitive the price movement is to changes in interest rates. This sensitivity was brought to investors’ attention in a painful way this year as interest rates have risen sharply and bond prices have fallen. While these price declines are a painful reminder that bonds carry risk, what investors need to remember is that bond returns, unlike stock returns, are fixed at the time of issuance only if held to maturity. Advisors and investors who have sold individual bonds, bond mutual funds or bond ETFs in this environment have created realized losses for clients that will be difficult to make up. Despite this difficult environment, it does not mean bonds should not be part of a diversified portfolio.

Interest rate volatility and bond duration

The path of a bonds return during its life will depend on several factors: First, the path of interest rates during the life of the bond. Second, the maturity of the bond at the time of issuance. Third, size of the fixed coupon the bond is issued with. When a bond is issued it has both a fixed coupon and a fixed maturity date (some bonds are issued with a floating rate coupon which largely negates the interest rate risk of the bond however, most bonds are issued with fixed coupons). The combination of a fixed coupon and a fixed maturity date determine the duration of each bond.  The duration is a measure of the interest rate risk or the price volatility of the bond as interest rates rise and fall.  For example, a bond issued with a fixed coupon of 3% and a maturity date of 10 years will have a duration of approximately 8.0. What this means is that an instantaneous rise in interest rates of 100 basis points or 1% will result in a price drop in that bond of 8% and conversely a 100-basis point fall in interest rates will result in a similar price increase. 

Two key points regarding the price volatility of a bond when interest rates rise or fall; First, as the bond ages – moves closer in time to its maturity date – the duration of the bond becomes shorter, and the interest rate risk/duration becomes smaller. The second thing that happens as the bond approaches its final maturity date is that the price moves back towards par or redemption value despite what is happening to interest rates.  That is because the bond yield or return is determined by its coupon, its discount or premium to par and the time remaining to maturity.  Using the example of the 10-year bond with a 3% coupon.  If the price of that bond falls to 95% of par immediately following issuance the yield or return of the bond to maturity would increase from 3% to roughly 3.25% since the investor who purchased the bond at 95 would receive the 3% coupon plus the 5-point discount amortized over the 10 years.  If the same bond were purchased at 95% of par with only three years to its final maturity the yield or return of the bond would rise to approximately 4.75%.  This relationship between price/coupon and maturity date is sometimes referred to as “rolling down the yield curve”.

Bond yields and time to maturity (the yield curve)

The following chart shows the relationship of US treasury bond yields and the time to maturity for two different dates in the past 8 years.  The bottom chart is the US Treasury yield curve in August of 2014 while the top chart shows the same relationship in its current form.  For over 90% of the time the relationship between short and long-term interest rates looks more like the lower chart – a positively sloped yield curve.  During periods when the yield curve has a positive slope bond yields and bond characteristics both benefit from the shape of the yield curve.  First as the bond approaches maturity it duration or interest rate risk is lowered. And second, with a positively sloped yield curve the yield naturally becomes lower which implies the bond price will rise. When only one of these characteristics in in place bonds will still become less risky over time but when both characteristics are in place, they work together to enhance the yield/performance of the bond and to reduce the interest rate volatility of the bond in question.

The US Treasury Yield Curve

Managing a Bond Portfolio
Fig. 1: Bloomberg – US Treasury Yield Curve

The yield curve and future bond returns:

Investors should not shy away from purchasing bonds in a rising interest rate environment. In fact that is actually the most advantageous time to purchase bonds.  First you are receiving a better yield/total return for the bond and second you are typically investing when rates have a better likelihood of eventually declining resulting in better returns than originally anticipated.  The final question investors should consider is should I purchase bonds with short maturities or bonds with longer maturities.  As discussed, the longer the time to maturity the greater the interest rate volatility of the bond but at the same time the better the yield or total return of the bond over its lifetime.  We advocate buying a mix of shorter dated bonds along with some longer dated bonds. The exact maturities would depend on the investors’ appetite for interest rate volatility as well as the shape of the yield curve at the time of purchase and the expectations of the future direction of interest rates.  In conclusion, we believe bonds remain an important part of an investment portfolio that can provide protection, reduced portfolio volatility and a better risk/return profile than many other portfolios. The recent increases in interest rates should make investors more positive on bonds given their future return potential has increased.

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