Whether they learn it the hard way or by reading up, most bond investors know that rising interest rates undermine bond values, because investors would rather own newer bonds that pay more.
That interest-rate risk is measured by a gauge called duration, expressed in years. A five-year duration means the bond or bond fund could lose 5 percent of its value for every one-percentage point rise in prevailing interest rates, while a drop in rates would push the bond price up by the same amount.
Shorter duration means less risk. But longer means greater potential return, because falling rates would drive prices up and because long duration means the bond has a longer maturity, which pays higher yield.
It’s dangerous to shorten your holdings’ duration just to be on the safe side, because shorter duration and maturity means lower yield. Too much safety means skimpy earnings.
[See: 7 ETFs to Buy as Rates Rise.]
With rates widely expected to rise as the U.S. economy gets stronger, what’s an appropriate duration to aim for today?
Michael Lee, principal at Investmark Advisory Group in Stamford, Connecticut, says that investors are wise to shorten the duration of their bond holdings to less than three years today.
“Duration should be at the core of your fixed-income strategy, and should directly correlate with your view on interest rates and risk tolerance,” he says, adding that decades of falling interest rates that drove up bond prices are now reversing.
“We’ve had a 30-year bond bull market that looks to be coming to an end,” he says.
“We currently recommend a very defensive positioning of your fixed-income portfolio, mostly in short-term, high-quality bonds or other securities that should not be adversely affected by rising interest rates,” says Anthony D. Criscuolo, portfolio manager with Palisades Hudson Financial Group in Fort Lauderdale, Florida.
Duration is valuable because it’s so easy to use, but understanding the calculation is like understanding what’s going on inside your smartphone. The beauty is you don’t need to know how it works to use it.
But for the record, here’s a simple summary: it’s the present value of a bond’s cash flows adjusted for the period during which they arrive and divided by the bond’s current market value.
Present value is what a sum to be received in the future is worth today, and it varies according to the interest rate that could be earned if that sum were invested in the meantime. A $100 payment to come next year has the value of $95.24 received today and invested for a year at 5 percent, so the present value is $95.24.
Duration is figured by adding the present values of all the bond’s cash flows, or interest earnings over time, and dividing the total by the bond’s current price.
Of course, the current price changes with market conditions, so duration will change, too, and investors are wise to keep an eye on it just as they’d pay attention to price changes. A duration that seems like a good mix of risk and potential reward one year may not be suitable the next.
“Longer term bonds — longer duration bonds — are more affected by changes in interest rates than shorter term bonds,” says Robert Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania. “In essence, duration is a measure of the interest rate sensitivity of bonds. For instance, when rates rise, the value of 30-year bonds falls more than the value of 10-year bonds.”
[See: 8 Reasons to Play It Cool When the Market Drops.]
That’s because the longer the bond has to maturity, the longer the bond owner will suffer from a below-market yield, or benefit from an above-market yield. If a bond will mature and return the investor’s principal tomorrow, it wouldn’t matter how much interest rates changed today.
“A good rule of thumb is that for every 1 percent increase in bond yields, a 10-year duration bond will fall by approximately 10 percent,” Johnson says. “Likewise, if bond yields fall by 1 percent, a 10-year duration bond will increase in price by approximately 10 percent. On the other hand, a bond with a duration of 30 years would fall 30 percent in value if bond yields rose by 1 percent. And, of course a 30-year bond will rise in value by 30 percent if bond yields fall by 1 percent.”
He adds, “In anticipation of a rising interest rate environment, a prudent move is to shorten the duration of your bond holdings.”
One valuable strategy is to match duration to anticipated spending, says S. Michael Sury, lecturer in the Department of Finance at the University of Texas at Austin. If you’ll need cash for a new car in three years, the bond holding could be adjusted to a three-year duration.
“By doing so, [the investor is] able to immunize or hedge the portfolio from adverse interest rate movements,” Sury says.
As valuable as duration is, it does not reveal the other big risk bond holder faces — the possibility the issuer will default and fail to pay interest and principal as promised, says Matt Hylland, investment advisor with Hylland Capital Management in North Liberty, Iowa.
“Duration is a way to measure the short-term risks of price fluctuations due to interest rates, but does not measure the risk of the bond issuer [not] paying on the bond,” he says.
Shifting to bonds with shorter maturities and duration generally means gaining safety but settling for lower yield. But Lee says the tradeoff is not so onerous today because the difference between short- and long-term yields has been shrinking.
Currently, a one-year Treasury note yields about 2.2 percent and a 10-year note 2.9 percent, not a huge difference.
“The yield curve is flat right now, meaning the interest you’ll receive from longer term bonds is very similar to what you would receive from shorter term bonds,” he says. “Because you won’t receive additional [yield], there is no benefit to adding or extending duration at the moment.”
[See: 7 of the Best Stocks to Buy for 2018.]
Shorter duration means greater safety, and today, the cost for that safety is small.
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How Shorter Duration Can Protect Your Bonds originally appeared on usnews.com
