Many people believe bonds are a safer alternative to stocks, especially when market volatility is high. Bonds pay interest on a regular schedule, and their value typically doesn’t fluctuate as much as stocks.
For the past 20 years, long-term interest rates have done nothing but decline. No one knows exactly when rates will rise, but we know they won't stay low forever. And it’s important to realize the bonds you own now could be at risk when rates head higher.
How do you know your bonds will lose value? Interest rates are the first place to look. Generally, when rates go up, the value of existing bonds goes down. As rates rise, investors will shop for bonds paying higher rates, and your bonds paying lower rates have less worth in the marketplace.
Maturity dates and durations are other good tools for assessing the impact rising interest rates will have on the value of your bonds. A bond’s maturity is the scheduled date when an issuer stops making interest payments and returns your principal. Duration is a measure of how sensitive a bond’s price is to changes in interest rates. It takes several factors into account, including time to maturity and the interest rate. Bonds with shorter maturity periods typically have a lower duration and are less at risk of declining in value than bonds with a longer maturity period. Let’s look at a couple of examples.
If you have two bonds that each cost $1,000 and pay 5 percent interest, but one matures earlier than the other, the one maturing first would repay your cost more quickly and is less at risk of declining in value if interest rates rise. And it would have a lower duration than the bond maturing later.
Now consider two bonds that cost the same and have the same maturity, but one pays a higher interest rate than the other. The one with the higher interest rate repays your cost more quickly, so it, too, has a lower duration. It will be less sensitive to future interest rates.
Today, you may be able to find bonds paying a higher-than-average rate, but you have to be careful about their maturity and duration because rates are so low. Interest rates could fall more, but they have much farther to rise, and that’s the greater risk.
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Sometimes bonds are issued with a call feature, which shortens a bond’s duration. The call feature creates the possibility a bond will be repaid early, and it’s why many bonds with long maturities, like 20 or 30 years, have durations much shorter than their maturities. When interest rates are falling, issuers are likely to call bonds because they can lower their interest costs. But when rates rise, issuers have little incentive to call bonds because it would raise their borrowing costs.
Mortgages are an example of bonds that let borrowers repay early, and that’s what happens when a borrower refinances a mortgage or buys a new home and repays an existing mortgage. As interest rates rise, fewer homeowners refinance, and fewer can afford to move up. With fewer mortgages repaid early, the duration on the mortgage and on mortgage-backed investments, like Ginnie Maes, extends. This means duration is an incomplete measure of mortgage investments’ price sensitivity in a rising rate environment. With today’s mortgage rates so low, this is especially important to keep in mind.
Now is a good time to check the types of bonds you have and their durations and interest rates. If they have long maturities and durations, you should consider selling them ahead of the rise in rates. If they have shorter durations and maturities, you'll be in a better position when rates edge higher.
Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast to coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.