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Bond Risk – You Should Understand This

riskPerhaps it is time to take a fresh look at your portfolio and make sure you have a better understanding of the bonds or bond mutual funds you may own. Bonds prices have generally been rising for around 30 years as interest rates have fallen. Interest rates have stayed at super low levels for some time now, buy how will your portfolio be impacted if/when they start going back up?

I came across the article below and thought it was a terrific explanation of the inherent interest rate risk all bonds incur.  If you choose to read this short explanation about bonds, you will know more about bonds than 99% of people that own them.

By: Jared Dillian

I’ve taken bond math classes out the wazoo. The best of them was in the summer of 2001 at Lehman Brothers. Lehman Brothers wasn’t going to teach a bad bond math class, not at the firm that became synonymous with bond trading itself. I was ready to start whipping ‘em around. Pity I ended up in stocks.

Now, the tables have been turned, and I am the old, wizened professor, dropping some knowledge on the younger generation. I occasionally teach finance to MBA students, and there are a couple of chapters on bonds where the students have to get their calculators out.

Monday’s class was all about duration, which is a concept most of you are hopefully familiar with. I like to say that duration has two definitions:

  1. The weighted average time to maturity of all coupon and principal payments
  2. The sensitivity of a bond’s price to changes in interest rates.

It is the second definition that most people know. If you own a bond, you are exposed (positively or negatively) to changes in interest rates. If interest rates go up a percent or two, you want to know what is going to happen to the price of your bond.

Two things we need to know about duration:

  1. Longer-term bonds have more duration
  2. Lower-coupon bonds have more duration

The on-the-run 30-year bond has a coupon of 2.25%, which is about as low as you can get, which means lots of duration. We’ll talk about this bond in a second.

So at the beginning of class, I asked everyone: “Are bonds risky or not?”

They said not.

Made for an interesting class.

Bonds Are Super Risky

There is a thumb rule in bond mathematics:

  • If interest rates go up one percent, the price of the bond will decline approximately (duration) percent.

It’s a thumb rule, it’s not exact2. So yes, if the duration of a 10-year note is 9, and interest rates rise from 1.6% to 2.6%, the bond will lose approximately 9% of its value.

So rates go up 1% and a bond goes down 9%. Is that risky?

You mean bonds lose value?

That will come as news to most people, because bonds are safe, you always get paid the par value in the end3.

Actually, bonds can lose a lot of value. And my guess is that people have been lengthening their duration in order to get a little extra yield. By moving into long-dated bonds, people have massively increased their interest rate risk.

Lots of people are in long-term government bond funds. Okay, so what is the duration of the on-the-run 30-year bond?

About 21 and change. So if long-term rates rise from 2.4% to 3.4%, the value of the long bond will decline by…

About 21%.

Are bonds risky? You bet.

What happens if interest rates rise by two percent? Certainly not unheard of.

The price of the bond will decline by 35-40%.

My guess is that people don’t know that their government bond funds could decline by 35-40%.

Now for my two cents:

The education provided above is spot on and they type of education that anybody with a Finance degree or in my profession should know all about. That being said, “bonds do have risk” and that risk should be addressed.  I have addressed that risk by making sure the “duration” in your bond portfolios is relatively low. Again that means if/when interest rates rise, bond prices go down less with lower durations.

A second way to lower the risk in your bond portfolio is to diversify not just between U.S. corporate and government bonds, but also to include bond mutual funds from all over the world.

If you would like to discuss the bond fund duration risk in your portfolio please do not hesitate to call me 630-942-9007 or email brad@fortunefinancialgroup.com.

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