Watch bonds as rates rise
Joel Dresang: Steve, we keep expecting the Federal Reserve to raise interest rates. What should bond holders be doing?
Steve Giles: I think it’s important for bond investors, Joel, to pay attention to the durations in their portfolios right now. What a bond investor wants to do is make sure they have a short- to intermediate-term duration when we expect or anticipate rates to go up.
Joel: What does duration have to do with it?
Steve: Well the duration is a measure of a bond’s sensitivity to that change in rates. The relationship between rates and values is in the inverse like a teeter totter. If rates go up, the values of our bonds are going to go down. If rates go down, the values of our bonds are going to go up.
Right now we’re in a very low interest rate environment. Everybody’s expecting that rates will be going up sometime later this year, which means that the values of our bonds are going to go down.
To get a sense of how much your value in the bond is going to go down, multiply the change in rates times the duration of your bond, and that’s going to give you the change in the bond’s value.
For example, if rates go up a half of a percent and you have a 10-year duration bond, you can expect your bond to pull back about 5%. If you have a two-year duration bond, and rates only go up a half of a percent, you’ll expect to take a 1% pullback.
Joel: What do we know from past rate increases and what that would mean to bond holders?
Steve: I think understanding what’s going to happen this time during the rate tightening cycle, it’s important to understand what happened the last two times that the Fed started to raise rates.
In 1994, Greenspan started to raise rates, but it was very unexpected. Nobody predicted it, and because of that, the bond market got roughed up. Unless you went to cash, you really didn’t hold up very well at all.
In 2004, having learned from his mistake, Greenspan projected that he wanted to raise rates. The bond market expected it, and those investors who went to cash got left behind as the investors who, in the more intermediate term phase, were able to see their bond values increase as their fund managers re-upped at prevailing rates.
Joel: So what do we expect – 1994 or 2004?
Steve: I think moving forward that investors should expect the bond market to play out more like 2004. Janet Yellen has been very good about having a very open-book policy. She has done a good job of forecasting their intention to raise rates, which means for us, as bond investors, if we stay in that short- to intermediate-term range, we should hold up OK.
Joel: So, in a rising rate environment, that favors bond funds?
Steve: A rising rate environment does favor bond mutual funds, Joel. Keep in mind that these funds have money coming due every single day, and as that money comes due, those bond managers are able to re-up their yields at the now higher rates in a rising rate environment.
Joel: So with all this going on, should bond holders be discouraged?
Steve: Absolutely not. I think bonds play a critical role in a well-balanced portfolio, and just because rates are anticipated to go up, if you properly position the durations in your portfolio, Joel, you should hold up well and do okay as a bond investor.
Steve Giles is vice president and investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May
(initially posted June 9, 2015)
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