INSIGHTS

On September 05, 2017

AAM Viewpoints – Duration Matters

There is an ongoing discussion of the Fed raising rates, global inflation growing and the unwinding of the FOMC (Federal Open Market Committee) balance sheet. Depending on how much weight you give these probabilities, they all point toward higher interest rates – the question is, “How much higher?”

With all the discussion about entering a rising interest rate environment comes the accompanying fear of the loss of market value of bonds.

One way to protect market value is to invest in bonds with shorter maturities. The shorter the maturity, the shorter the duration. The shorter the duration, the less of an impact rising rates have on the market value of a bond.

Below is an example of how duration is a measure of the impact of higher interest rates. The three generic bonds listed below all have a coupon of 5% and all are impacted by the same 1% move upward in rates. The variable being the maturity and duration based on the maturity and coupon. As illustrated, the longer the maturity/duration the greater the market loss due to a 1% increase in interest rates.

Source: AAM | For illustrative purposes only.

With the 5-year Treasury yielding a 1.70 and the 10-year Treasury currently yielding around a 2.10, these benchmark bond yields make it tough for investors to feel like they are receiving any kind income from their bond investment. This problem is accentuated by the potential market loss that would come from higher rates.

There are various investment strategies that an investor can explore to invest in a rising interest rate environment. One strategy is investing in cushion bonds. A “cushion bond” is a bond that has a large coupon rate, thus a high premium dollar price, and has an optional callable feature. With a premium dollar price bond, the date of the call feature effectively acts as the maturity date of the bond when calculating the value of the bond. As long as there is a premium dollar price, if interest rates move higher, the impact on the bond value should be relatively smaller than a bond with the same maturity but with no call option, thus “cushioning” the change in the bond value. See Exhibit A below. This strategy can help protect bond values relative to non-callable similar structures while potentially providing the investor higher yields. Typically the yields received on a cushion bond are somewhat higher than an otherwise comparable non-callable bond.

Exhibit A:

Market value loss with 1% rise (100 basis points) from 2.5% yield based on current market rates to 3.5% yield in interest rates on a Cushion Bond vs. a Non-callable Bond with the same final maturity. (The percentage moves are rounded and the dollar value of the bonds are still premiums after the 1% rise in interest rates.)

Source: AAM | For illustrative purposes only.

The down side to a cushion bond? The structure is more complicated, investors may not like paying a premium dollar price for a bond and the investor needs to pay more attention to the investment. These are also among the reasons why the investor can usually obtain better yields on cushion bonds than on a comparable non-callable bond. The cushion bond, when bought for this type of strategy, works as described when there is a premium value to the bond. When buying a cushion bond, in our opinion, the premium paid for the bond must be high enough to withstand a rise in interest rates and still carry a significant premium after the interest rate move. There are various stress tests to determine how a bond value will react to an interest rate move. A simple one is to take the current value of a cushion bond and apply a 100 bps (basis point) move up in interest rates to see what the bond value would be after the rise in rates. For example, the value of a bond is $116 at a given time. If after a 1%, or 100 bps, move up in interest rates the principal value of the bond is still expected to be in that $106-or-greater range, then you probably have a good cushion structure. The idea is that a cushion bond is a potentially good strategy if the bond structure can withstand a rise in rates and still have a cushion. This example is for illustrated purposes only.

CRN: 2017-0905-6130R