Scott W. O’Brien, Director of Wealth Management
According to Morningstar, in May the average bond fund dropped in value by nearly 7% when interest rates spiked. This followed much speculation about the possibility and timing of when the Federal Reserve may end their bond-purchasing program. The timing is important, as this program and the quantitative easing programs before it have been holding interest rates down in an effort to stimulate the economy.
The investment philosophy at WorthPointe Wealth Management is to hold fixed income assets (bonds) that are shorter term and higher quality. By short term, we mean 5 years or less in duration, which is a measurement of interest rate risk.
Interest rate risk can be demonstrated as follows: If a bond portfolio has an average duration of 3 years and interest rates rise by 1%, its principal value will drop by 3%–the duration multiplied by the interest rate change. It works in the opposite direction as well; if interest rates were to drop by 1%, the principal value would rise.
It might be helpful to view this discussion by visualizing a teeter-totter or seesaw.
Rates go up, principal goes down. Rates go down, principal goes up.
Since interest rates have generally been on the decline for the last 30 years, the total return on bonds has been quite strong. Investors reaped the interest from them, and saw the value of their bond portfolio rise.
With interest rates now at near-historical lows, this scenario is likely to change. There simply isn’t much room for rates to go down. Following the reversion to the mean concept (things return to their averages over time), eventually rates will rise again.
Sometimes, we get questions about our bond portfolios and why we have them at all if we aren’t getting much interest and the risk of rising interest rates may harm the principal value.
We hold bonds for the downside protection in case of stock market declines. Bond price movements (especially high-quality short-term bonds) typically have an inverse relationship to stock market movements. We saw this in 2008 when during the financial panic shorter-term U.S. Treasury securities prices rose dramatically, offsetting some of the losses in the stock portion of portfolios.
While struggling with this low interest rate environment, we have been explaining to our clients that we are resisting the temptation to chase higher yields by buying longer-term bonds or lower-quality higher-risk bonds. It just isn’t worth the risk, as we saw last month when interest rates rose again.
This chart from Dimensional Fund Advisors shows why having longer-term maturities is not worth the risk. You will note that after the 5-year mark, while the interest rates do rise a little, the volatility as measured by standard deviation dramatically spikes.
A different chart illustrates the effect credit quality has on the volatility (the blue line) as measured by standard deviation. Similar to the previous chart, the interest received (gold line) on bonds increases slightly as the quality decreases, but at the point that the bonds reach less than investment grade (BBB), the volatility spikes dramatically.
Based on statistics from the end of September, our clients’ bond portfolios have an average duration of less than 2 1/4 years and we use only funds that invest in high- quality investment-grade bonds.
When you have a portfolio that owns bonds that have 1-, 2-, 3-, 4-, and 5-year maturities, if (when) rates start going up, you will soon have some of the bonds (the 1- year bonds) maturing. The proceeds from the maturing bonds can be invested in the higher interest rate environment. Thus, as rates rise over time, your portfolio will have bonds maturing and reinvesting at the higher rates.
This strategy decreases the volatility of the bond portfolio and takes advantage of rising rates while holding this asset class for downside protection for the overall portfolio.
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