This is the second article of two examining the role of bonds in your portfolio. The first article reviewed what bonds are, identified factors that influence bond returns, and considered some popular ideas for responding to bond risks. This article will assess rising interest rate implications for both your portfolio and your financial plan.
You save and invest and build a portfolio to fund spending in the future. You have stocks in your portfolio in the hope of earning high returns. High returns mean less saving to fund future spending (or more future spending for the saving you do). You hold bonds for predictable returns – while average bond returns are likely to be lower than average stock returns, you are much more confident about the bond returns you’ll receive than about stock returns.
Bonds and your spending plans
Whether your plans for future spending, perhaps for retirement or college for your children, are vague or more specific, you have some idea of how much you might spend and when you might spend it. To make things simple, let’s think about spending you might plan for one specific year in the future, and let’s imagine that you can specify a dollar amount for that spending.
How much money do you need to have today to fund that spending? How much money would you need to put into a CD today to have enough when the time arrives to spend? That amount of money is called the present value of your future planned spending.
The present value depends on how much you want to spend, when you want to spend it, and the interest rate your CD will pay between now and then. Just as with bonds, the higher the interest rate, the lower the present value and, the less you’d need to save to fund the spending. If the interest rate was lower, you’d need to save more, and the present value would be higher.
Suppose that instead of buying a CD, you’ve decided to fund a particular payment of $1200 in 20 years with a bond that matures in 10 years, 10 years before your payment is due. You spend the present value of your future payment for the bond. With the interest rate of 2%, you pay about $825 for your bond. You expect to buy another 10-year bond paying the same interest rate when the first one matures.
Now suppose that the interest rate rises to 3%. The price of your bond falls from $825 to $775. In 10 years, though, your bond still matures at $1,000. The borrower keeps their promise! Because the interest rate is now 3%, you need only $900 to fund the $1200 you want to spend in 10 more years. You have extra! Surplus! The rise in interest rates helped you, even though your bond declined in value.
If you had known that interest rates were going to rise, you could have spent even less for the first bond – about $700.
However, no one can predict the future.
Now suppose a similar situation, but you plan to spend $1,000 in 10 years. Unfortunately, no 10-year bonds are available, so you buy a 20-year bond, again at 2%, which matures at $1,219 10 years after the payment is due. You plan to sell the bond for $1,000 in 10 years to make the payment.
Now, if interest rates rise to 3%, your bond will be worth only $907 when you sell it in 10 years. That’s less than you planned. You’ll have to make an additional payment to cover the difference after you sell the bond. In this case, the rise in interest rates hurt you.
Now, suppose that you fund your future $1,000 payment (ten years out) with a (ten-year) zero coupon bond. The price of the bond will be equal to the present value of the payment. And, once you’ve bought the bond, interest rate changes don’t affect your ability to fund the payment as the table below illustrates.
It is still true that if interest rates rise, you may wish you had waited to buy the bond. But that is a market timing issue. Again, advance information is required for the perfect bond purchase.
Now, let’s consider your bond holdings in the light of your entire situation. Your lifetime balance sheet provides a concise summary of your assets, your liabilities, and your planned spending.
The example shows assets of $6M, including human capital or future earnings, real estate, and financial assets: stocks and bonds. Liabilities include a mortgage, some other loans, and a lot of future payments. Total liabilities are $3.8M leaving a net worth or surplus of $2.2M.
We’ve seen that rising interest rates both reduce the value of your bonds and reduce the present value of your future payments. If interest rates rise, what will happen to your net worth? If the present value of your future payments goes down more than the value of your bonds, your net worth actually increases! On the other hand, if the present value of future payments doesn’t go down as much as your bonds do, you lose – your net worth will decline.
Bond duration and your spending plans
How can you tell? The concept of duration allows us to answer that question. The definitions below lay out the concept, and the table of numbers illustrates.
The table calculates the duration of a 5-year 5% bond. If there were no principal payment, the average arrival date would 2.5 years out. If there were no coupon payments the average arrival date would be 5 years out, when the principal arrives. The principal payment is larger than the interest payments, so the duration of the bond, 4.25, is closer to 5 than 2.5 – the weight on the principal arrival date is larger.
As our earlier examples illustrated, if the duration of your payment stream is longer than the duration of your bond, higher interest rates help you, because the present value of your payment stream drops more than the present value of your bond when interest rates rise. Higher interest rates hurt you if your payment stream has shorter duration than your bonds – the value of your bonds drops more than that of your payment stream. If the durations are the same, interest rate changes don’t affect you.
So, what does all this mean for you? A couple of examples may help – let’s think about college funding (4 equal payments starting at a child’s age 18) and retirement funding (30 equal payments starting at age 70). The tables show how duration of those payment streams changes as your child, or you get older.
These payment streams have durations that start out high or long, and then decrease rapidly as the final date of the payment stream approaches.
Finally, the last table (I promise!) contains durations for some basic bond mutual funds and a sample portfolio weighting. The foreign bond fund has the longest duration, and the Short TIPS fund has the shortest. As you might guess, the sample portfolio’s duration falls in between.
The funds and the portfolio all have durations shorter than either payment stream in the early phases. As a retiree gets to be 85 or so, the duration of their bond portfolio begins to become a consideration. Similarly, as a prospective college student moves from 10 toward 15, it’s worth thinking carefully about portfolio duration.
What to do about your bonds
Safeguarding your financial plan by managing your bond portfolio composition in the context of the payment streams you need to fund is much easier than forecasting interest rates.
It’s conventional wisdom that when interest rates are rising, investors should do something to protect their bond assets. Options include:
- Holding cash, which won’t go down in value when interest rates rise. However, getting better return from this option than simply holding bonds requires excellent market timing.
- Buying higher yielding bond funds, which may still have positive returns even if rates rise. However, getting better return from this option requires taking on more credit risk (risk of borrower default). Investors may not receive enough extra return to compensate for the higher risk.
- Buying stocks. However, stocks are riskier (and stock values also decline when interest rates rise).
Interest rates are still low and increases are likely to occur over the next year or so, continuing for some time. Unfortunately, the conventional wisdom is at best misleading and can be harmful for two very important reasons.
First, the time pattern of interest rate increases is completely unpredictable. In fact, it is not even certain that rates will increase further from here. The Federal Reserve is certainly signaling that it intends to raise the Federal Funds rate further, but the Fed can change its mind, and other interest rates don’t move in lockstep with the Federal Funds rate. Selling bonds to buy shorter maturity bonds, to hold cash, or even to buy stocks, in the hope of better returns amounts to market timing – which is generally not advisable.
Second, while the immediate impact of rising interest rates on the value of your bond and bond fund holdings is clearly negative, its impact on your financial position is less clear. If you happen to hold individual bonds with maturities matched to your planned future payments, higher interest rates don’t affect your financial position at all. If the duration of your payment stream is longer than the duration of your bond portfolio, higher interest rates improve your position. However, if the duration of your payment stream is lower than the duration of your bond portfolio, higher interest rates are unfavorable for your financial position. You may wish to adjust your bond holdings accordingly.
Having a clear understanding of what you are saving and investing for can help you make much better investment decisions and reduce your stress level. You can match (even approximately) the duration of some bond assets and some of your spending plans without forecasting interest rates. The best investment strategies for you are simple and easy for you to follow even in times of market stress. These are strategies you can implement and stick to.
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