Investment Articles

06/05/04 - Controlling Interest Rate Risk

By: Richard Feldman, CFP, MBA, AIF

In the late 1990's a popular conversation you would hear at cocktail parties centered around the stock market.  I am sure you know what I am talking about because people were only to willing to brag about how much money they had made on Yahoo, Ebay, Cisco, Intel, EMC and many more before the inevitable technology bubble burst in March of 2000. Fast forward a few years and a funny thing has happened recently in that the stock market banter has turned to interest rate banter.  "I just refinanced my 30 year mortgage into a 15 year mortgage at 5.25% and still decreased my payment by $200 a month or I just bought my new place and I got a five year ARM at 4.25%".  If you listen to the Wall Street analysts and economists it seems the interest rate party is almost over.  With interest rates trading at historical low's Wall Street and the general public has recently turned increasingly pessimistic about interest rates and the direction they are heading in leaving a lot of individuals wondering how to protect themselves and their portfolio's against rising rates.  Most people I talk to are confused about how interest rates work and specifically how a rise in interest rates will affect their fixed income investments.

It's all about Duration

Most individuals know that bond prices fluctuate with interest rates and that longer maturity bonds tend to fluctuate more from changes in interest rates but most individuals are not familiar with the concept of duration.  Duration is a weighted average of the times that interest payments and the final return of principal are received. The weights are the amounts of the payments discounted by the yield-to-maturity of the bond. The reason why duration is a better measure of volatility than average maturity is that duration takes into account differences in coupon rates.  A 10 year bond with a 5% coupon will be more sensitive to interest rate swings than a 10 year bond with an 8% coupon.  The reason being that the 8% bond pays the investor $80 per year which means the investor will get paid back faster with the higher yielding bond rather than the five year bond that pays the investor $50 per year (Assuming a $1,000 face amount).

Duration is the single most important measure of how risky most bonds are because it measures their sensitivity to interest rate changes.  Duration tells you how a bond or a bond fund will react to a one-percentage point change in interest rates.

The formula to figure out how a change in interest rates will affect a bond fund is as follows:

Realized Gain/Loss = -Duration [Change in interest rates  ÷  1 + Yield to Maturity]

For example: a bond has a Yield to Maturity of 7.5% and the bond has duration of 12.4 years.  If interest rates rise 1% the investor would lose 11.53%.  Change in Bond price = -12.4 (.01 ÷1.075) = -11.53%.

Interest Rates

Even though the Federal Reserve has not changed the federal funds rate, interest rates have been rising for the last year based on the expectation that the Federal Reserve is going to begin to tighten monetary policy because of the strengthening of the economy.  To follow is a chart of the 10 year treasury constant maturity (Data taken from the St. Louis Federal Reserve).

 

As you can see from the chart above intermediate term rates have risen approximately a full percentage point from their levels in March of this year.

Managing Duration

The sensitivity of a bond's price to changes in market interest rates is influenced by three key factors:  time to maturity, coupon rate, and yield to maturity.

• Holding time to maturity constant and yield to maturity constant, a bond's duration and interest rate sensitivity are higher when coupon rate is lower.
• Holding the coupon rate constant, a bond's duration and interest rate sensitivity generally increase with time to maturity. Duration always increases with maturity for bonds selling at par or at a premium to par.

To shorten the duration of a bond portfolio you can purchase shorter term to intermediate term bonds that are selling at a premium to par.  If you invest your fixed income assets through fixed income mutual funds select a fund with a duration of less than five years.  That way if interest rates continue to rise you will limit your downside risk of the portfolio.

Summary

Fixed income investors face three types of risk:  interest rate risk, default risk, and re-investment risk.  Keeping the duration of your portfolio short will limit the risk of the loss of principle in your fixed income portfolio and allow your portfolio to adjust to higher rates quicker because the rate at which you reinvest the income from your portfolio will be higher.  Over time, reinvestment of interest on your bonds at higher rates adds up, allowing you not only to offset your initial loss of principal but also to profit more than if rates had never moved at all.

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