By: Investor Solutions

By: Investor Solutions, Inc.

How safe is your bond portfolio in an increasing interest rate environment? Surging prices in the housing and commodity (specifically oil) sectors have triggered inflation fears that have prompted the Federal Reserve to increase the federal funds rate seven times since June of 2003, the most recent hike occurring last week. The fed-funds rate is the rate that banks charge each other for overnight loans. As the fed funds rate increases, interest on short term securities also goes up. Those rate hikes, despite inspiring higher bond yields for investors, can have a negative impact on the price of your bonds. This article will reflect on why this happens and what you should do to protect yourself.

Investing in bonds is not a risk-less exercise. Many investors are mistakenly under the impression that bonds do not lose value. In fact they do.

Bonds are subject to a number of risks, including:

• Default risk: risk of bond issuer defaulting on debt (also known as credit risk)
• Reinvestment rate risk: The risk that proceeds received in the future (i.e. coupon payments) will have to be reinvested at a lower potential interest rate.
• Purchasing Power risk: risk that inflation will lower value of bond interest payments or principal repayment, forcing prices to fall
• Interest rate risk: risk that a change in interest rates will cause market value of bond to fall. Interest rate risk as it relates to bond duration is important to understand.

Understanding Duration and Interest Rates

Duration is defined as the weighted measure of time it will take for a bondholder to receive the interest and principal of a bond. Duration, of course, does consider the coupon payments. So, for two bonds with the same maturity, the bond with the higher coupon rate is said to have the lower duration.

A bonds duration is of critical importance for investors. When interest rates rise, the price of an outstanding bond will fall to bring the yield of the older bond into line with the higher interest new issues. Conversely, when interest rates fall, the price of an outstanding bond will rise, until the yield of the older bond is low enough to match the lower interest rate on new issues.

Lets say for example, Jane owns a 30 Year Bond with a par value of $10,000. At the time of purchase five years ago, the bond had a 4% yield. Lets also assume that new bond issues now offer a yield of 6%. Jane no longer wants to keep her lower yielding bond, opting instead for the bond with the 6% yield. The only way that Jane will be able to unload her bond (whose yield is below current market yields) will be to sell it at a discount (or below par). Her bond is worth less than its face value, because interest rates went up.

Therefore, in a rising interest rate environment, as we are now experiencing, investors should consider lower duration (maturities with 5 years or less) bonds because as interest rates increase, the value of their bond will depreciate. While, investors holding bonds with longer durations will likely experience a capital depreciation of their bond.

Duration and Volatility

From the time a bond is issued, bond prices and yields will fluctuate according to market conditions. Any change in the level of interest rates will have an immediate and predictable effect on the price of bonds.

There is a direct link between a bonds maturity and its yield. Long term bonds have historically provided higher average returns than short term bonds. Thats no secret. However, since long term bonds are much more sensitive to interest rate fluctuations, they are also more volatile as measured by standard deviation (as illustrated in the following table).

1965 to 2004 1 YearTreasury Bill 5 Year Treasury Note 30 Year Treasury Bond

Geometric (Annualized) Return 6.97% 7.68% 7.71%

Annual Standard Deviation 3.29% 6.61% 11.63%

Growth $1 $1,378 $1,831 $1,851

Source: Dimensional Fund Advisors

One of the best observations we can make from this chart is the vast difference in standard deviation between the 5 year note and 30 year bond. Long term bonds are substantially more risky than short duration bonds for not much more benefit. The return for the long term bonds is a paltry .03% higher, while the standard deviation is a whopping 5.02% higher. There is simply not much benefit to owning a long bond position. Why? Investors are exposed to far greater risks (recap: reinvestment, interest, purchasing power, and default risk) the longer you hold a bond.

Persistent and rapid economic growth can lead to inflation, thereby provoking the Fed to tighten monetary policy by increasing rates. This, of course, would erode a bonds value. We are experiencing this right now. As an investor, you need to understand how bond prices are influenced by such economic cycles. One of the best ways to guard against interest (and the other) risks it to control the duration of your bonds. Regardless of the direction of interest rates, investors should really consider bond portfolios with durations of less than five years. So, if youre long right now in the current rate environment, I suggest you go short&.and stay there.