Here are four investment strategies investors can use to avoid losses due to rising interest rates.
In this episode you’ll learn:
- The importance of focusing on the present
- Why bond prices fluctuate as interest rates change.
- What fixed income strategies avoid interest rate risks.
How Rising Interest Rates Impact Bond Prices
U.S. interest rates began 2016 at a level where ten-year U.S. Treasury bonds were yielding 2% and thirty-year Treasury bonds were yielding 3%.
Following the Brexit vote in June 2016, yields got as low as 1.4% for ten-year Treasury bonds and 2.1% for thirty-year bonds.
After such a sharp decline in interest rates, long-term Treasury bond ETFs gained over 20% year-to-date through early July.
Those ETFs have since given up most of the gains. With the election of Donald Trump as President and his post election pledge to both cut taxes and accelerate spending on infrastructure, interest rates have been climbing and yields for ten and thirty-year Treasury bonds are now close to where they began the year.
There is no way to know if interest rates will keep rising but the potential for a larger annual federal budget deficit under a Trump administration has certainly gotten the bond market’s attention.
Bonds and Interest Rates
Why do bond prices fall when interest rates increase and rise when interest rates decline?
Consider an investor who bought a newly issued thirty-year Treasury bond that yields 2%. The bond pays $20 in interest annually for every $1,000 of bond face value. The face value is the price of the bond that the interest payment is based on.
If interest rates rise to 3%, then an investor who buys a newly issued thirty-year bond would receive $30 in annual interest.
Seeing that an investor can now buy a new bond that pays $30 in interest while the old one pays only $20, the old bond’s price must fall to a level that an investor would be economically indifferent investing in either of the two bonds. In other words, the price of the old bond must fall to a level that an investor would make the same amount of money holding the old bond as he or she would owning the new bond.
The degree to which a bond’s price changes as interest rates fluctuate depends on when the bond matures, its yield, coupon payment and other features.
A bond or a bond portfolio’s price sensitivity to changing interest rates is known as its duration. Duration is essentially the weighted average maturity of a bond or bond portfolio’s cash flows.
A thirty-year bond receives cash payments in the form of interest for three decades compared to just a few years for a five-year bond. Consequently, the duration or weighted average maturity of the cash flows for a thirty-year bond will be much higher than for a five-year bond.
The higher (i.e. longer) a bond or bond portfolio’s duration, the more its price will change as interest rates change.
That is why an exchange traded fund that invests in Treasury bonds with maturities greater than twenty years appreciated over 20% as interest rates fell 1% between January and July this year while an ETF that invests in bonds with maturities of seven to ten years only appreciated by just over 8%.
The latter ETF had a shorter duration than the ETF that invested in bonds with maturities greater than twenty years.
A rule of thumb for duration is a bond’s price will increase or decrease by its duration multiplied by 1% for each 1% point change in interest rates.
For example, if interest rates rise by 1%, a bond or bond portfolio with a duration of six years will fall by approximately 6%.
Even though a bond’s price fluctuates with changes in interest rates, an investor who holds the bond to maturity will receive the original face value when the bond matures and the annualized return will equal the bond’s yield to maturity at the time it was purchased. The investor is made whole even though it may have been a bumpy ride as interest rates changed along the way.
Interest Rate Risk
Most investors don’t own individual bonds, however. They own bonds through mutual funds or ETFs. The managers of these investment vehicles don’t necessarily hold the bonds to maturity, and they are always buying and selling bonds based on the cash flow into and out of the fund or ETF.
Consequently, bond fund and ETF investors are subject to interest rate risk.
If interest rates continue to rise, these bond investors will see their funds or ETFs decline in value. That is why understanding a fund or ETFs’ duration is so important.
While bond fund and ETF investors can be hurt in the short-term if interest rates increase, if they continue to hold the fund or ETF for approximately seven years or more, the investors will make up the losses. Their total annualized return for the seven to ten year holding period will approximately equal the fund or ETF’s starting yield to maturity or in the case of U.S. investors, the fund or ETF’s SEC yield.
So a bond fund such as the Vanguard Total Bond Market Index Fund that currently yields 2% and has a duration of 5.8 years, might fall by close to 6% for each 1% increase in interest rates. Yet, an investor who holds the fund for seven to ten years would most likely achieve an annualized return of 2%.
The reason for this is the initial losses due to rising interest rates are offset over time by the fund or ETF receiving and reinvesting interest income at higher rates.
There is one type of bond ETF that allows investors to avoid interest rate risk. These bond ETFs, such as iShares iBonds and Guggenheim BulletShares, have fixed maturities that correspond to the year listed in the specific ETF’s name, such as 2017, 2020, etc.
In other words, the ETFs hold bonds that mature the year the ETF expires. When the designated year arises and the ETFs bond holdings mature, the ETF is delisted from the exchange and cash is returned to the investor.
While the ETF will fluctuate in value as interest rates change, if the investors holds the ETF until maturity, they will earn the yield-to-maturity that the ETF had at the time the investor made the purchase.
For example, the iBond Dec 2020 Term Corporate ETF owns over 400 corporate bonds that mature in the year 2020. The ETF yields approximately 2%. That means an investor who holds the fund until it matures in 2020 will achieve a return of 2% annualized irrespective of whether interest rates rise and fall between now and 2020, thus mitigating the risk of rising interest rates.