The Impact of Interest Rate Changes (Part 2)

Yesterday's post set the groundwork for understanding the mechanics of getting an approximation for the impact of a change of interest rates on portfolio return.  The poll by Edward Jones revealed that many investors are confused by the impact.  This isn't good because investors, and especially retirees, have piled into bonds and bond funds over the past several years in search of yield as the Federal Reserve and global central banks have driven short-term yields close to zero.

So let's take another look at this important influence on portfolio return.  Suppose we agree with what seems to be the consensus - that rates will move higher over the long term -  but still appreciate the fact that the consensus could be wrong and that rates could stay fairly stable or even drop from here. Assume further that our asset allocation calls for 40% of investable assets in fixed income.

One way to play this would be to invest 50% of the fixed income portion in CSJ and 50% in AGG. CSJ lowers the yield of the fixed income portion but also reduces considerably the price volatility.  In other words, it is a bit of a hedge relative to the overall bond market.

Following the approach presented yesterday, we would go to Morningstar and get the yield and the duration of CSJ and AGG.  The yields are 0.86% and 2.40% for CSJ and AGG respectively.  The durations are 1.96 years and 5.08 years for CSJ and AGG respectively.

So what would be the approximate impact if yields rose 1.50% (10-year Treasury yield rises from 2.80% to 4.30%) over, say, the next 6 months?  To figure this out, note that the bond portfolio is equivalent to having an ETF with a yield of (.86 + 2.4)/2 = 1.63% and a duration of  (1.96 + 5.08) = 3.52 years.

The impact of a 1.50% rise over 6 months could then be approximated at -3.52 * 1.5 =  -5.28 (price change) plus 1.63/2 = .815, or a total impact of -4.465%.  This, of course, will be multiplied by .4 because the fixed income portion represents 40% of portfolio assets.

It is important to understand that the short-cut method here is an approximation.  The actual outcome will be influenced by the shape of the yield curve (short-term rates and long-term rates don't all fall by the same amount), the actual accrued interest on the ETFs, and even the premium or discount on the ETFs relative to their respective NAVs.  Still the approximation shown here should help in lessening the surprise investors could get with a sharp rise in rates.