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Unique Measure of Interest Rate Risk: Bond Duration
Recently, the Federal Reserve has indicated that inflation doesn’t appear as “transitory” as they thought, so interest rates are probably on the rise. This will cause bonds to lose value because a rise in rates causes bonds to sell at a discount. The choice facing the financial planner is to advise enduring the pain now and sell at a discount or spreading the pain over the remaining life of the bond via coupon payments lower than market.
By Kevin P. Brosious, CPA, PFS, CFP
Bonds aren't the slam-dunk safe investment they once were. For this, we can thank the current interest rate environment. The federal funds rate is 0.08%, and the U.S. Federal Reserve has been keeping interest rates artificially low by purchasing $80 billion of Treasury securities and $40 billion of agency mortgage-backed securities (MBS) every month since June 2020. Recently, though, the Federal Reserve has indicated that because inflation doesn’t appear as “transitory” as they thought, interest rates will probably rise early next year, and they will begin buying fewer bonds each month going forward. All of this will cause bonds to lose value.
Declining interest rates like we’ve experienced for the past 40 years benefit bond holders, but a rise in rates causes bonds to sell at a discount. Think of it this way: why would investors pay $1,000 for a five-year bond paying 2% interest if they can purchase a newly issued five-year bond paying 3% for the same price? Because of the change in interest rates, the 2% bond will sell at a discount, and the market price will drop to $954, a loss of 4.6%.
Of course, you can hold an individual bond until maturity, collect your semi-annual interest, and get back your initial $1,000 investment. But then you would be stuck with a bond paying less than the market rate of interest for the remaining term of the bond. The choice is to endure the pain now and sell at a discount or take the pain over the remaining life of the bond via coupon payments lower than market. Note: because of the way most bond funds are structured, you'll take the principal hit upfront but you'll also get the higher interest payment.
Investors can estimate how sensitive their bonds are to rising interest rates (interest rate risk) by using a bond’s “duration.” Duration measures the percentage change in the market price of a bond for a percentage change in interest rates. For example, a bond that has a duration of 5 years can be expected to lose 5% in principal value for every 1% increase in interest rates. In other words, if you paid $1,000 for this bond, and interest rates increased 1%, the market value of your investment would drop to $950. The same principal applies to bond fund investments; the fund’s duration is readily available in the prospectus or fund fact sheet.
The question at hand is, if interest rates are moving up, how much risk do you want to assume with your bond investments? More risk usually equals more reward, and bonds with longer maturities will pay a higher coupon rate but also have a higher interest rate risk. Consider the iShares Investment Grade Corporate Bond Fund. The fund is yielding 2.2%, but it has a duration of 9.6 years. If rates increase 1%, the value of your investment will fall 9.6%.
Conversely, the yield for the Vanguard Short-Term Corporate Bond is 0.9%, which has a duration of 2.8 years. Considerably less return, yes, but it also has much less exposure to interest rate risk. An investor in this fund can expect their investment principal to fall 2.8% for every 1% increase in interest rates. As you can see, the investor in long-term bonds sacrifices bond stability for higher coupon interest.
Don’t forget: except for U.S. Treasury Bonds, all other bonds have credit risk (which is the risk that the borrower is unable to pay their loan obligation in full). Take the Vanguard Short-Term Corporate Bond mentioned above. The fund is an investment-grade bond fund, but a significant portion of the fund (48%) is invested in BBB-rated bonds. Although they are investment grade, they are also only one step above junk bond status. In the low-interest-rate environment, many funds changed the makeup of their bond holdings by increasing the percent of lower-grade bonds in their portfolio to increase the funds’ return.
When investing in bonds, remember that risk and reward are always linked. Bonds paying higher interest carry more risk. Using a bond's duration to determine potential interest rate risk can be a useful tool for the CPA adviser.
Kevin P. Brosious, CPA, PFS, CFP, is president of Wealth Management Inc., located in Allentown and Plymouth Meeting. He can be reached at kevin@wealthmanagement1.com.
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