The Federal Reserve anticipates raising the federal funds rate in either late 2015 or early 2016 after keeping record low interest rates for a number of years in the wake of the 2008 financial crisis. This would generally result in bond prices sinking lower. The Fed has stated any interest rate hike will be limited. The plan is to raise rates gradually as the economy improves. The extent to which a rate hike impacts a bond portfolio depends on the portfolio’s duration and where along the yield curve the portfolio is situated.
Bonds and interest rates have an inverse relationship. As interest rates increase, bond prices generally fall. As interest rates fall, bond prices go up. Bonds generally pay a stated interest rate, also known as a coupon rate. New bonds are issued in relation to the current prevailing interest rates. Bond investors are constantly looking for the best returns on their investments.
Assume an investor owns a bond that pays a 5% annual coupon rate. If interest rates go up to 6%, new bonds being issued reflect these higher rates. Investors want to own bonds with the higher interest rate. This reduces the demand for bonds with lower rates, including the bond only paying 5% interest. Therefore, the price for those bonds goes down to coincide with the lower demand.
On the other hand, assume interest rates go down to 4%. Bonds that pay 5% are more attractive. Therefore, there is greater demand for bonds with higher interest rates. As a result, bond prices go up since there is increased demand for the bond paying 5%.
Another important consideration for a bond portfolio is the yield curve. The yield curve refers to a graph that plots interest rates, at a certain time, of bonds having an equal credit quality with different maturity rates. The most common yield curve is based on U.S. Treasurys since the government has never defaulted on its debt and the credit quality is consistent across the different maturities.
Rate hikes have different impacts on different maturities of bonds. The general rule is the longer the maturity of the bond, the greater the drop in price in response to an interest rate hike. Shorter maturity bonds are not impacted as greatly by interest rate hikes. Thus, the maturity of the bonds an investor holds in a portfolio determines the extent to which it is impacted by an interest rate hike.
Duration of Portfolio
The duration of the bond portfolio is another important element to consider. Duration refers to how long it takes for the price of a bond to be paid by its internal cash flows. Assuming constant coupon rates, the longer the time to maturity for a bond, the higher the duration. Bonds with longer durations carry more risk. Their prices are also more volatile since they have greater sensitivity to changes in interest rates.
Duration is a helpful statistic for measuring the risk of a bond portfolio. It provides the effective average maturity of the portfolio. It further provides an estimate of the sensitivity of the portfolio to changes in interest rates. The overall duration of a portfolio can be used to help immunize the portfolio from interest rate risk. More sophisticated investors may want to use derivatives to offset this interest rate risk. The easiest way to help immunize a bond portfolio against interest rate risk is to adjust the duration of the portfolio to meet the investor’s time horizon. When a bond portfolio is immunized, the investor obtains the same rate of return no matter what happens to interest rates.