WASHINGTON — The recent volatility in the bond market may be a “warning shot across the bow” for investors as the yield on the10-year treasury rose to its highest level in the past nine months. Is this a signal that it’s time to heed the warnings that the bond market “bubble” is ready to burst?
While the Federal Reserve has said that it anticipates raising interest rates this year if the economy meets certain job growth and inflation requirements, it’s unknown when interest rates will go up and by how much.
You don’t need a crystal ball to know that the bond market, and therefore investors, have greater risk to rising interest rates now more than ever, but it’s helpful to understand why.
Three factors at or near their historical highs or lows illustrate this increased risk:
1. Duration is the longest in history
Duration is the most common way to measure interest rate risk. If you need a refresher, Morningstar has a great definition of duration.
Simply put, the longer the duration, the greater the potential loss of value when interest rates rise. However, this depends on whether you are a borrower or a lender.
Borrowers — such as corporations, municipalities and the Federal Government — have taken advantage of the current interest rate environment to issue bonds at low rates of interest and with longer maturities.
While these lower interest rates are good for them, they’re not good for lenders such as individual investors. And as borrowers have locked in current low rates for a longer periods of time, the duration of the bond indices has increased to historic lengths.
2. Yields are close to their lowest levels in history
The yield on the Barclays Aggregate Bond index has steadily declined from 10 percent in March 1989 to its current yield — a paltry 2.4 percent. That’s not a lot of income cushion to offset any potential decline in the price of your bond portfolio as interest rates climb.
Read: The Best Way to Invest in Bonds In A Rising Interest Rate Environment
3. The yield buffer is the lowest in history
In order to understand the impact of longer duration and low yields, let’s use a real-life example of one of the largest bond funds today and look back at its history.
According to Morningstar, over the past 30 years, the Vanguard Total Bond fund has experienced six years when the principal loss in the portfolio was more than 2 percent. However, because the income return in each of these years was sizable, no single year resulted in a total return loss greater than 3 percent.
For instance, in 1987 the rise in interest rates caused the price of the Vanguard Total Bond fund to plummet by a whopping -7.6 percent. Because the income return was so high at 9.2 percent, the fund still had a total return of 1.5 percent. The income was more than enough to offset the principal loss.
See the table below:
| 1987 | 1994 | 1996 | 1999 | 2005 | 2013 | |
| Income Return | 9.17 | 6.37 | 6.51 | 6.19 | 4.47 | 2.33 |
| Price Return | (7.63) | (9.03) | (2.92) | (6.95) | (2.07) | (4.60) |
| Total Return (Income + Price) | 1.54 | (2.66) | 3.58 | (0.76) | 2.40 | (2.26) |
| Average Effective Duration | 4.6 | 4.6 | 4.7 | 5.0 | 4.6 | 5.5 |
(Source: Morningstar, Glassman Wealth)
By comparison, the current yield today is a mere 2 percent. This, coupled with an effective duration of 5.6, offers the least amount of cushion to offset any rise in interest rates in the fund’s history. As an over-simplified explanation of duration, a 1 percent rise in interest rates will cause a 5.6 percent decline to its current principal value.
Investors may be surprised to find that their traditional bond portfolios could experience more volatility when interest rates rise than other times in history. Not just because interest rates are low, but because bond indexes have greater interest rate risk coupled with a tiny buffer to help offset losses. While this may not occur for some time, perhaps it’s time to pay attention to those warnings.
What should investors do?
Shorten your bond duration: According to the Investment Company Institute, more money has flowed into longer duration bond funds since October 2014 from investors seeking better yields. If you are one of them, you may want to make a change to shorter duration funds which are typically less affected by changes in interest rates.
Retirees may want to consider these strategies that could potentially increase their yield while reducing their interest rate risk: Best Bond Investing Strategies for Today’s Retirees.
Exchange interest rate risk for credit risk: I like going shorter-term for a lower quality bond fund. Two examples we use at Glassman Wealth are Osterweis Strategic Income (OSTIX) and Nuveen Short Duration High Yield Muni (NVHIX).
