As an investment consultant that manages fixed income portfolios, I have often discussed the implications of interest rates on portfolios. Those conversations usually begin and end pretty interestingly. However, I would have to say that by and large the impact of interest rate moves on existing portfolios (and portfolio construction for that matter) is over-stated. As with every accusation you have to find someone or something to blame, so I blame…THE MEDIA! It seems through “media distortion” only half-truths are told (or heard–if I were being trying objective) by the attending public. This is to say, that if you own bonds in your investment portfolio and have listened to any major news outlet in the last several years, you probably have heard that interest rates will inevitably rise. In particular, once this happens the value of any bonds in your portfolio will dramatically drop. Here’s the truth…
False Notion #1: “When the Fed raises interest rates, it will cause a decrease in my portfolio value”.
Incorrect. The first thing to understand as a bond holder is that your main risk to manage is credit and interest rate (these two are widely viewed as the most important). Credit risk is the risk that your cash flow or principal repayment doesn’t happen in future periods. This is directly a function of how financially solvent the bond issuer is going to be in the future. Interest rate risk (or also duration risk) is the risk that higher interest rates decrease the current market value of your bond. (Note the emphasis on current market value as opposed to maturity or future value). The media doesn’t usually tell you that interest rate increases do nothing to affect the maturity value of your bond holdings. Why? Because as a bondholder you have a covenant (or contract) that states the final value is a fixed number. This is why credit risk is a more appropriate focus of energy when it comes to discerning good investments.
False Notion #2: “When the Fed raises interest rates, it will affect the entire yield curve the same way.”
Incorrect. Parallel shifts in the yield curve are rare and it is unlikely that this next one will be parallel. So let me first explain the difference between a parallel shift versus a non-parallel shift. A parallel shift would mean that the 1, 5, 10, etc. year rates all move equally by the same amount either upward or downward. A non-parallel shift would mean that the 1, 5, 10, etc. year rates move unequally by some amount either upward or downward. Now, which do you think is more likely to happen? I would bet on the latter, because historically that is what normally happens. The non-parallel shifts are called “twists” and frankly the impact to the portfolio is hard to measure. However, there are techniques to immunize the effect on the portfolio. The scope of this discussion is not designed to cover that, but suffice to say your investment advisor should be able to construct a portfolio that protects against that.
False Notion #3: “Regardless, any move in interest rates upwards will be bad for my portfolio.”
Incorrect. Just because bond prices move opposite of interest rates doesn’t spell doom for your fixed income holdings. I think the main message here is know your total return. Total return is defined as the change in value plus income. An interest rate increase will only affect the “change in value” portion of the equation. The income portion of that equation is actually improved when you consider that the income can be reinvested in the increased rate environment and generates even more income to the portfolio. Reinvested income, or compounding, is the way to take advantage of a higher rate environment. No matter the maturity of your bond holdings, longer term investors have the distinct advantages of reinvesting their coupon income for even greater returns that will likely offset the change in value. The change in value can be estimated with duration. Let’s say that the duration of your bond portfolio is 6.0, that means for a 1% increase in interest rates, your bond portfolio will decrease by approximately 6%.
So the next time you are tuned into your favorite news channel and they mention that the likely effect of the impending rate hike will mean catastrophe for your portfolio, hopefully you don’t do something incredibly harmful like sell your bonds.
“It ain’t what you don’t know that gets you into trouble, it’s what you know for sure that just ain’t so.”- Mark Twain
Maybe this profound aphorism should be expanded to include “…and what you’re told that just ain’t so”!