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 start gradually raising the federal funds rate – the benchmark for the prime and other consumer interest rates – as the U.S. economy strengthened. And so it has; in fact, it has hiked the s by a quarter percentage point three times in 2018 alone (as of October).
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 already 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 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%. 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.
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 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 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.
The Bottom Line
Bond investors are constantly looking for the best returns on their investments – returns that can be adversely affected by changes in the fed funds rate, which impacts interest rates.
More sophisticated investors may want to use derivatives to offset this interest rate risk. Otherwise, the easiest way to help immunize a bond portfolio against risk is to adjust the duration of the portfolio to meet the investor’s time horizon by, say, building a bond ladder. When a bond portfolio is immunized, the investor obtains the same rate of return no matter what happens to interest rates.