Rate
changes don’t affect all equally
I received
a note from a reader a short time ago asking specific questions about how a
short-term bond fund might protect her portfolio from rising interest rates.
Rates have already started rising, albeit slowly, but that may continue if our
economy continues to roll. The impact of rising rates on bonds isn’t as
straightforward as most think.
The general
relationship between bond prices and interest rate changes can be illustrated
with a visual of a teeter-totter. Picture interest rates sitting on one end,
with bond prices (not yields) on the other.
As interest
rates come under downward pressure, bond prices will be pushed up – and vice
versa. This is so because the actual dollar amount of interest a bond pays is
set for the life of the bond. With a fixed dollar amount of interest, a rising
(falling) price will mean a lower (higher) yield. Just think teeter-totter.
When
interest rates change, they usually don’t move in tandem across all different
terms to maturity. For instance, we have seen an increase in short-term rates
so far this year, while long term rates have remained rather flat.
Even when
rates do move together in the same direction, they almost never move by the
same amount. For example, the drop in mid-term bond yields was two to three
times the drop in short- and long- term rates seen over the past year.
The point
of all this is that blanket advice such as “sell your government and
investment grade bonds because rates are rising” can be somewhat
misleading.
Ignoring
for a moment the unparallel nature of rate changes, it’s time to review a few
ground rules.
Bonds with
longer maturities are more sensitive to rate changes than those with shorter
maturities. This is so because the maturity value is much farther into the
future. If a bond matures next week and short-term rates fall, who cares?
You’ll be able to cash in your bond for the full maturity value within days.
Hence, as a bond approaches maturity, its market price gets more closely tied
to its maturity value.
Bonds with
lower coupon rates (i.e. rate that determines semi-annual interest payments)
are more sensitive to rate changes than those with higher coupon rates. Having
more interest paid out semi-annually speeds up a bond investor’s payback period
(i.e. how long before interest payments “pay back” original investment). Along
that same line of thinking, strip bonds are very sensitive to rate changes
since they pay no periodic interest.
Bonds with
lower credit risk (i.e. higher credit rating) are more interest-rate sensitive
than those with higher credit risks. The higher the risk of the bond issuer,
the higher the yield that investors will demand. If the issuer improves its
business by improving cash flow and profitability and strengthening its balance
sheet, it may see its credit rating upgraded – and the yield on its bonds fall.
Such an event will typically trump the pure impact of any interest rate
changes.
Finally,
the bump up in price from falling rates is generally higher than the price
decline resulting from rising rates. Trust me – this is how it works due to
something called “bond convexity”. The point of mentioning this is that there
is a favourable bias to the impact of rate changes.
Shifting
most or all of your bonds to shorter-term issues (or a fund emphasizing such
bonds) in anticipation may provide a false sense of security. Such a move will
limit damage somewhat but the yield potential is quite limited – particularly
if rate hikes are concentrated on the short end.
If rates
rise more gradually, short-term bonds may not do so well, compared to other
types of bonds. I’m not changing my tune on this. My advice from a few months ago
still stands.
Keeping
proper diversification within your bond component – i.e. short-term, high
yield, real return, and mid-to-long term government – should ensure its role as
the portfolio stabilizer you need it to be going forward.
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling
Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.