When investors look back at the spring of 2013, they may say it was the moment when the bond market finally shifted and a new trend of higher interest rates emerged. It appears that the long-awaited reversal of the bond market has begun. In early May, the yield of the 10-year treasury hovered at just above 1.6 percent. While that wasn’t the all-time low (1.379 percent in July 2012), it was pretty close. We have all known that bond yields would have to rise, eventually. We’ve known that at some point the fear of the financial crisis would recede, the economic recovery would become self-sustaining and the Fed would stop purchasing bonds. Whenever that occurred, the 30-year bull market in bonds would come to an end, pushing down prices and increasing yields
Many bond market moves look benign in the rear view mirror, but they can feel pretty dramatic in real time. The rise in 10-year yields from 1.62 percent in the beginning of May to a 16-month high of 2.35 percent in mid-June might not seem like a big deal – just 0.73, right? But it’s important to realize that it’s a 45 percent move in just 6 weeks!
What does that kind of move mean to your portfolio? It means that many of your bond positions have lost value, because as interest rates rise, the price of bonds drops. The magnitude of your hit is partially tied to the duration of the holding. Duration risk measures the sensitivity of a bond’s price to a one percent change in interest rates.
The higher a bond’s (or a bond fund’s) duration, the greater its sensitivity to interest rate changes. This means that fluctuations in price, whether positive or negative, will be more pronounced. Short-term bonds generally have shorter durations and are less sensitive to movements in interest rates than longer-term bonds. The reason is that bonds with longer maturities are locked in at a lower rate for a longer period of time.
For those of you who own individual bonds, the price fluctuations that occur before your bonds reach maturity may be unnerving, but if you hold them to maturity, you can expect to receive the face value of the bond.
If you own a bond fund, it may be scary to see the net asset value (NAV) of the fund drop when rates increase. To soothe you a bit, remember that when NAV falls, the bonds within the fund should continue to make the stated interest payments. As the bonds within the fund mature or are sold, they can be replaced with higher-yielding bonds, which could create more income for you in the future. Additionally, if you are reinvesting interest and dividends back into the fund, you may benefit from purchasing shares at lower prices.
To help protect your portfolio against the eventual rise in interest rates, you may be tempted to sell all of your bonds. But of course that would be market timing and you are not going to fall for that, are you? Here are alternatives to a wholesale dismissal of the fixed income asset class:
Lower your duration: This can be as easy as moving from a longer-term bond into a shorter one. Of course, when you go shorter, you will give up yield. It may be worth it for you to make a little less current income in exchange for diminished volatility in your portfolio.
Use corporate bonds: Corporate bonds are less sensitive to interest-rate risk than government bonds. This does not mean that corporate bonds will avoid losses in a rising interest rate environment, but the declines are usually less than those for Treasuries.
Explore floating rate notes: Floating rate loan funds invest in non-investment-grade bank loans whose coupons "float" based on the prevailing interest rate market, which allows them to reduce duration risk.
Keep extra cash on hand: Cash, the ultimate fixed asset, can provide you with a unique opportunity in a rising interest rate market: the ability to purchase higher yielding securities on your own timetable.
So even if this truly is the turnaround in the bond market that we’ve all been waiting for, there’s no reason to be afraid. Just pay closer attention to your bond holdings, and know how to protect yourself from rising rates!
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