You add fixed-income investments to dampen volatility in an all-equity portfolio that you know will someday see a day of reckoning. But fixed-income or bond type investments are not necessarily a slam dunk in terms of reducing volatility in a portfolio and hence careful evaluation and planning needs to be incorporated when incorporating (ha…) these instruments into your portfolio. To understand the implications, a brief primer on bonds and the underlying bond pricing theory.
You own a stock in a company and you are an owner regardless of how small a stake you own in that company. The business prospers and you prosper. That business fails and the value of your stake in that company or its stock price goes to zero. Owning a bond on the other hand makes you a lender – you lend your capital to a government or to a business for a fixed term and in return the borrower promises to pay interest each year for the life of that term at the end of which you get your original capital or principal back. Sounds pretty straightforward and safe so what’s the risk?
The most fundamental of all risks to the price of a bond is changes in interest rates. The yield on a 10-year treasury bond for example jumped from 1.5% to about 2.4% in the past 18 months. That is almost a 1% increase. Now in the grand scheme of things, it doesn’t sound much but this magnitude of a move for a relatively long term bond is a pretty big deal. If you want to know what it means to your bond portfolio, you must understand what a duration is. Most folks don’t buy individual bonds and instead prefer to invest in a bond mutual fund or an exchange traded fund. So pictured below is a snapshot and portfolio characteristics of the iShares 20-Year Treasury Bond ETF (TLT).
And you see the effective duration for this bond ETF at 17.28 years. If you know the duration of your bond or a bond fund, you would then know how much money you would potentially lose in a rising interest rate environment. Technically, duration explains the amount of time it would take in years for an investor to recover the true price of a bond considering the present value of its future interest payments and the final principal repayment. Sounds confusing? A more detailed explanation in this embedded link below.
Circling back to that bond ETF with a 17.28 years duration, if market interest rates jump by say 2%, the price of this bond fund will decline by roughly 34%. That’s 1/3rd gone out of the value of your investment. And it’s not like it may decline. It will because unlike equity prices with expectations theory built in, the change in bond prices is pure math. A lot of folks rely on municipal bonds for tax-free income but these bonds carry a lot of risk considering that most of these bonds have a duration in the 12 plus year range. If interest rate were to go up by say 1%, you would lose 12% of your principal. What’s a muni bond yielding these days? 3%? 3.5? 4% if you are lucky. You lose 12% means you lost 3 to 4 years worth of income. If rates go up 2%, you lose 24%. That $1,000 you have invested in this supposedly safe investment just turned to $760.
And many are a bit complacent considering that interest rates have done nothing but go down over the last 30 years and bond prices have done nothing but go up. That is highly unlikely to be repeated over the next 30 years. And the point here is not to ignore bonds from your portfolio if you need them but to include the right type of bonds with the right duration and credit quality because when interest rates move higher and move higher they will, bond prices will decline and some by a lot.
Image credit – Kathleen Tyler Conklin, Flickr