Many people think they can’t lose money in fixed income securities unless a company goes bankrupt. Technically, that’s true if you hold every bond to maturity. However, when interest rates rise, your fixed-coupon bond starts earning a below-market rate of interest. This risk is duration, and duration has caused many fixed income benchmarks to have negative returns year-to-date in 2018. We believe duration risk remains high in the second half of 2018 as well. Therefore, keeping duration low in your fixed income portfolio remains crucial.
Since a bond’s yield is the sum of the market interest rate at issuance plus the bond’s credit spread, an increase in interest rates or credit spreads will negatively impact the prices of previously issued bonds with fixed coupons. Interest rates are rising, so the only question remaining is: how much will bond prices fall? Through Friday’s close, the 2-year Treasury rate has risen 0.71% to 2.59% while the 10-year Treasury rate has risen 0.49% to 2.89%. The current 2-year Treasury bond has a duration of ~1.9, and the current 10-year Treasury bond has a duration of ~8.6. This implies that a 1% instantaneous increase in interest rates will cost you 1.9% on a 2-year Treasury, and a very substantial 8.6% if you bought a 10-year Treasury bond. Most investors underappreciate the risk attached to government bonds. This same interest rate risk applies to longer-dated corporate bonds as well.
To better understand how dramatically the recent interest rate movement could affect a bond portfolio, think about making a $100 loan to a friend’s company. You lend your buddy $100 for one year at a 3% interest rate. Suppose, however, a week later interest rates on the same type of loans rise to 5%. Technically, you didn’t lose any money (your bank account balance remains unchanged), but another investor wouldn’t pay you $100 to take that loan and its corresponding cash flows off your hands. This is because the interest you expect to earn on that loan is stuck at $3 as opposed to the $5 you would have earned had you made the loan one week later. Another investor would only be willing to take that loan if you dropped the price to ~$98, whereupon the new holder of the loan would receive a 5% return (getting $103 back in 51 weeks, after laying out $98 today).
Now let’s assume you made the same $100 loan, but this time the loan is due in 10 years. You would be missing out on an extra $2 of interest every year for 10 years, and this would prove to be extremely detrimental to the present value of that loan you made. The fair value of your investment would be ~$84. This is a very big potential loss for a ‘safe’ fixed income investment, an asset class most investors think can’t lose them money provided no bankruptcies occur.
This example illustrates the significant effect duration can have on the value of a fixed income portfolio. The example illustrates that in a rising interest rate environment, duration can be very costly, because as rates move up the value of the cash flows associated with loans/bonds/preferreds can potentially decline dramatically.
Now think about how the bank feels if you had refinanced your 30-year mortgage two years ago when national average 30-year mortgage interest rates were ~3.4% as opposed to ~4.4% today. You are paying a below-market interest rate on your mortgage and you won’t refinance it again unless you sell your home or interest rates fall below your current rate. In this case you are the borrower, and the bank is in the investor. The bank sure wishes you would refinance, but the bank will just have to live with ~3.4% for the next 28 years. This is what happens to investors who buy a corporate 30-year bond at a low interest rate right before rates rise. A fixed-rate corporate bond paying a 3.4% coupon and maturing in 28 years when market rates have risen to 4.4% will trade down to approximately $84. If market interest rates on such bonds rose to 5.4% this same bond would trade down to approximately $71. These examples illustrate the significance of duration risk in longer-dated bond prices.
As you can see in the examples above, you would much rather protect against potential interest rate increases by making a one-year or two-year loan rather than one for 10 years. Right now the bond market is only paying you an extra ~0.30% to make a 10-year loan versus a 2-year loan. This is occurring as inflation is picking up, the economy is strong, and the Fed is planning on two more rate increases in the next six months alone.
As evidenced by the graph of the 2-year and 10-year Treasury rates above, investors are being paid very little to take significantly higher interest rate risk. This 2-year vs 10-year Treasury spread is a key benchmark used by fixed income investors to assess whether investors are being paid sufficiently to take duration (interest rate) risk. The graph clearly illustrates duration just doesn’t pay right now, and if interest rates continue to rise, such exposure could have a significant negative impact on your fixed income portfolio. This is precisely why we are keeping the duration of our fixed income holdings in clients’ accounts exceptionally short.