For years, in the wake of the 2008 financial crisis, the Federal Reserve kept interest rates at record lows. Then, in 2015, it announced a policy to gradually raise the federal funds rate—the benchmark for the prime and other consumer interest rates—as the U.S. economy strengthened. And so it did. In fact, it hiked rates by a quarter percentage point four times in 2018 alone.
But in 2019, the Fed reversed course, cutting rates by a quarter percentage three times. In 2020, it reduced the rates twice in March alone, cutting it by 50 points and then by another 100 points.
It may not be the most riveting news out there, but the federal funds rate has a real impact on virtually every borrower and every lender by making money more or less expensive to obtain. And it is of great relevance to every investor in bonds.
A rise in the fed funds rate, as it's known for short, would generally result in bond prices sinking lower. But 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.
By bond prices, we're referring to previously issued bonds trading on the secondary market. New bonds are issued with coupon rates (the stated, fixed amount of interest they pay) in keeping with the current-prevailing interest rates.
The reason for this is simple economics. 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 naturally want bonds with a higher interest rate. This reduces the desirability of bonds with lower rates, including that bond paying only 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%. That bond paying 5% is now more attractive, right? There's increased demand for bonds with higher coupons that pay more. So prices on prevailing bonds go up.
The Yield Curve
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 but with different maturity dates. The most common yield curve is based on U.S. Treasury bonds since the U.S. government has never defaulted on its debt and its high credit quality is consistent across the different maturities.
Rate hikes have different impacts on bonds with different maturities. 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 the length of time 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 that interest rates will change for the better. Their prices are also more volatile since they are more sensitive 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 also 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.
The Bottom Line
Like all investors, bond investors are constantly looking for the best returns on their investments. But for bond investors, returns can be adversely affected by changes in the fed funds rate.
Some investors use derivatives to offset this interest rate risk. If that doesn't appeal, the easiest way to help immunize a bond portfolio against risk is to adjust the duration of the portfolio. Building a bond ladder is one strategy. When a bond portfolio is adequately immunized, the investor gets the same rate of return no matter what happens to interest rates.