In light of the low interest rate environment we have experienced for the past couple of years, it’s a good idea to review how rate changes impact bonds given the near certainty rates will rise at some point in the future. Bonds are simply loans that investors make to an issuer for a period of time in exchange for a specified interest rate on the amount loaned to the issuer. The value of the bond prior to maturity can be affected if interest rates increase or decrease. Below are a few highlights regarding the relationship that exists between interest rates and the various bond portfolio ownership structures:
- The Federal Reserve oversees open market operations as their primary tool to implement monetary policy. By increasing or decreasing the amount of money in the banking system, the Fed attempts to steer short-term interest rates.
- Interest rates and bond prices are inversely related. An increase in rates leads to a decrease in bond prices and vice versa.
- Interest rates and bond yields are directly related. An increase in rates leads to higher bond yields, while the inverse is true as well.
- Duration is a measure of the sensitivity of a bond’s price to changes in interest rates. Bonds with low durations (1-2 years) are less sensitive to interest rate changes than bonds with longer durations (15-20 years). A rule of thumb is that if interest rates increase by 1%, a bond fund’s value will drop by approximately the fund’s duration. Therefore, if rates where to increase by 1%, a bond with a short duration of 2 years (value would drop by approximately 2%) is less sensitive to this change when compared to a bond with a long duration of 10 years (value would drop by approximately 10%).
- Portfolio turnover is important in the bond fund structure. A fund which invests in primarily short-term bonds will be able to reinvest at a much quicker pace than a fund with longer term bonds. This turnover allows for reinvestment in higher yielding bonds whereas the longer maturity portfolio must do so over a longer period of time.
- Bond funds allow for dividends paid at the end of each month to be reinvested automatically. This benefits investors in periods of increasing interest rates with a long term investment horizon. As rates increase, the value of underlying bonds falls and reinvested dividends benefit from a lower cost.
There is a great deal of uncertainty as to when interest rates will increase again. However, investors with a long term investment approach who hold short-term, high quality bonds benefit as these positions with low interest rate sensitivity can react quicker to rate changes than their longer term counterparts.
Please contact your financial planner if you have any questions regarding this blog entry.
