With interest rates on intermediate- and long-term bonds ticking up a good bit over the beginning of the year, many investors are refocusing on the potential risk within bond portfolios. (As one data point iShares 20+ Treasury ETF is down about 1.8 percent year-to-date.) For many bond portfolios, that risk can come from either interest rate risk or credit risk. Here I’ll focus on interest rate risk.
The potential interest rate risk in a bond or bond fund portfolio is largely determined by its average maturity — or more appropriately its duration — and how volatile interest rates are. Longer duration and higher interest-rate volatility mean that potential losses are higher when compared to shorter duration portfolios and periods with relatively low interest-rate volatility. One of the more informative ways to understand bond market risk is to analyze how a particular portfolio of bonds would perform if interest rates were to increase by some amount (for example, 1 or 2 percent) over a given period of time.
Before doing this analysis, it helps to understand how much interest rates tend to move around on a year-to-year basis. The best data source I have for long-term interest rate data is the St. Louis Federal Reserve's FRED database. Looking at the annual data series for the five-year Treasury bond, one finds that since 1962 there have been 11 years (or 22 percent of all years) where the yield increased by more than 1 percent and two years where it increased by more than 2 percent.
So, a reasonable starting point for examining bond market risk is understanding what would happen to a bond portfolio with an average maturity of five years if rates were to increase by 1 or 2 percent over the next year. I’ll examine these scenarios by assuming we buy a five-year Treasury bond today and hold it for a year. During that year, its yield increases by 1 percent. Then, we’ll examine what would happen if its yield increased by 2 percent.
Currently, the five-year Treasury bond is trading at about $100.52 and yielding about 0.77 percent. If we assume that its yield increases by 1 percent in one year, it would then be trading at roughly $96.63 for a total return of –3 percent. If rates were to increase by 2 percent, the bond would be trading at a price of $93.00 for a total return of –6.6 percent. So, we can see that interest rate increases comparable to some of the largest moves we’ve seen in U.S. history would certainly produce sizeable losses, but not nearly as bad as what a bad year in the stock market would look like. (Of course, I have to caveat that rate increases could always be larger than what we’ve seen historically, but this at least gives some perspective.)
Now, though, let’s examine longer-term bonds, specifically the 30-year Treasury bond. Currently, the 30-year Treasury bond is trading at about $100.82 and yielding about 3.08 percent. If its yield were to increase by 1 percent, its price would fall to about $83.81 for a total return over the year of about –13.8 percent. If the yield were to increase by 2 percent, its price would fall to $70.48 for a total return of about –27 percent (ouch!), clearly exhibiting the impact that maturity has on downside risk.
Random Links and Commentary of the Week
Good piece by Zach Lowe on NBA players to watch for the second half of the season.