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April 4, 2013

Bond Investors Beware – FINRA Issues Warning on the Effects of Rising Interest Rates

Last month, FINRA put a warning out to all bond investors…If interest rates rise – as many market professionals expect – bond investors could be slammed by long duration.  FINRA is the largest independent securities regulator in the U.S. Their…

Bond Investors Beware – FINRA Issues Warning on the Effects of Rising Interest Rates

cautionLast month, FINRA put a warning out to all bond investors…If interest rates rise – as many market professionals expect – bond investors could be slammed by long duration.  FINRA is the largest independent securities regulator in the U.S. Their chief role is to protect investors by maintaining the fairness of the U.S. capital markets.  In an investor alert, the Financial Industry Regulatory Authority Inc. told investors that in the event of rising interest rates, “outstanding bonds, particularly those with a low interest rate and high duration may experience significant price drops.”  A bond fund with 10-year duration will decrease in value by 10% if rates rise one percentage point, the alert warns.

What Happens When Interest Rates Rise

Duration is an important term that any bond investors should know. The term duration has a special meaning in the context of bonds. It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.  Although stated in years, duration is not simply a measure of time. Instead, duration signals how much the price of a bond investment is likely to fluctuate when there is an up or down movement in interest rates. The higher the duration number, the more sensitive a bond investment will be to changes in interest rates (Bond-fund investors can find measures of duration in a fund’s fact sheet and individual bond investors can check with their investment professional, the bond’s issuer or use an online calculator to get the figure).

Interest rates are at or near historic lows. There is not much room for them to move lower; most economists believe they will rise in the future. If that is true, then outstanding bonds, particularly those with a low interest rate and high duration may be at risk. Money in long-term bonds should be expected to decline in value, perhaps significantly, when interest rates rise.  Those portfolios with high exposure to long term bonds should be reviewed, as many investors may find out the hard way that their investment allocations are no longer in line with their goals and objectives.

What Duration Does to Price 

Many factors impact bond prices, one of which is interest rates. An adage of bond investing is that when interest rates rise, bond prices will fall, and the same could be said for the opposite. Advisors call this interest rate risk.  Some bonds are more sensitive to interest rate changes than others. Duration risk is the name economists give to the risk associated with the sensitivity of a bond’s price to a one percent change in interest rates.

The higher a bond’s duration, the greater its sensitivity to interest rate changes. This means that the volatility in price will be greater given a higher duration.  A bond held to maturity will be paid back at the par (or face) value of the bond, unless the company goes out of business or otherwise fails to pay.  Where duration matters is if a bond is sold before maturity, say because of a liquidity need, the price received will be affected by the prevailing interest rates and duration.

For instance, if interest rates were to rise by two percent from today’s low levels, a medium investment grade corporate bond (BBB, Baa rated or similar) with a duration of 8.4 (10-year maturity, 3.5 percent coupon) could lose 15 percent of its market value. A similar investment grade bond with a duration of 14.5 (30-year maturity, 4.5 percent coupon) might experience a loss in value of 26 percent.  The higher level of loss for the longer-term bond happens because its duration number is higher, making it react more dramatically to interest rate changes.

Variables such as how much interest a bond pays during its lifespan as well as the bond’s call features and yield, which may be affected by changes in credit quality, play a role in the duration computation. Maturity, the length of time before the bond’s principal is repaid, can also play a role. Duration is an extremely important figure to aware of when investing in bonds particularly when interest rates are low.  Keep in mind, these are only general guidelines.  Duration assumes that for every movement in interest rates, there is an equal change in bond price in the opposite direction. However, this isn’t always the case. For example, when interest rates drop, a residential mortgage-backed security (a bond backed by home loans) might not see an equal increase in the bond’s price, because it might prompt homeowners to refinance their loans. This in turn may limit increases in the bond’s price as it loses interest paying loans being paid off.

Low Duration Doesn’t Equal Low Risk 

Just because a bond or bond fund’s duration is low, does not mean necessarily that the investment is low risk. In addition to duration risk, bonds and bond funds are subject to inflation risk, call risk, default risk and other risk factors. These factors will be discussed in a bond’s offering document or a bond fund’s prospectus.

-Posted by Chris

Sources:

http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/Bonds/P204318

http://www.investopedia.com/university/advancedbond/advancedbond5.asp

 

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