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Sunday, August 25, 2013

The Impact of Rising Interest Rates on Portfolios

Here are the numbers from an Edward Jones study interviewing 1,008 people as reported by Barron's (8/26/2013, p. 16).

63% said they don't know how rising rates affect their investment portfolios.
24% say they're completely in the dark about potential effects.
33% of respondents between 18 and 34 admit they don't know the impact of rates.
19% of men said they don't understand the specific impact.
First off, to understand rate movements and bond returns, investors need to understand that bond prices and interest rates move in opposite directions.  When rates rise, bond prices drop and vice versa. Secondly, in addition to the change in price, bond returns are impacted by accrued interest.  Thus, holding a bond with a yield of 3% will contribute that yield to the total return over the course of the year and will add to the impact of the unrealized capital gain or loss.  Over a 6-month period, it will contribute half of that, or 1.5% and so on.

The trick, then, is to get a handle on what will happen to bond prices as yields change.  For this purpose, the investor needs the duration of the bond portfolio or the individual bonds.  Let's back up a moment and think about this.  At first cut, a little thought will reveal that a bond with a longer maturity will have a price volatility greater than that of a bond with a shorter maturity.  But, this isn't enough. Consider two bonds with 5-year maturities, but the first bond pays a coupon of 5% and the second bond pays a coupon of 2%.  These are clearly two different animals with very different cash flows.  In fact, the bond with the 2% coupon has a more volatile price because its cash flows come in slower.

This difference is handled by a metric known as duration.  Duration is the key to estimating the impact on bond prices from a change in yields.  Let's consider a simple example.

Go to Morningstar, an excellent source for finding bond fund durations, and put AGG into the quote box.  AGG is the ETF which tracks the Barclay's Aggregate bond index.  It is used by many investors as the main investment for their bond or fixed income assets.  Hitting the quote button brings you to a page from which you need two pieces of information:  the yield and duration.

Source: Morningstar
As shown, yield on AGG is 2.40%.  On the same page, scroll down and find the duration on the right hand side.

With this information at hand, calculating the approximate impact of a change in yields is straightforward once you understand that duration tells you the change in price per 1% change in yields.  For example, assume that AGG comprises 40% of our portfolio and assume that yields rise 1% over the next 12 months (for example, the yield on the 10-year Treasury note rises from 2.9% to 3.9%).  Then the impact on portfolio return would be approximately .4*(-5.08+2.4%) = -1.07%.  If yields rise 2%, the impact would be approximately .4*(-10.16+2.4) = -3.90%.

If you play around with this, you can see the impact of time (getting 2.4% yield over 12 months as a cushion), portfolio weighting (the .4), etc.

It is a fairly simple step to bring in other bond funds or even individual bonds once you have their durations and yields.  Hopefully, you can see here how the recent sharp rise in yields over a short period of time, as well as the possibility of a longer-term increase, has unnerved investors.  And, hopefully, this short explanation reduces the percentages of people who don't understand the impact of bond yields on their portfolio  ;)