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AAM Viewpoints – Bond Duration in a Rising Interest Rate Environment


As of this writing, the yield on the benchmark 10-year Treasury bond is currently at 2.85 which is 45 basis points (bps) higher in yield than on January 1. The current feeling by many observers is that yields will rise given new tax regulations, stimulus package and inflation seemingly on the rise.

  • The highest yield ever on the 10-year Treasury was 15.84% at close of business (COB) 9/30/81.
  • The lowest yield on the 10-year Treasury was 1.35% at COB 7/18/16.
  • That makes an average between the high and low over this period of time a yield of 8.59%.
  • However, just sticking to this century; the highest yield was 6.78% on COB 1/20/2000, which makes the simple average between the high and low a 4.06% yield.

I happen to think that a 4.06% yield on the 10-year Treasury is not unreasonable to expect some time in the future. This 4.06% yield on the 10-year Treasury bond is roughly 120 bps – or 1.20% – higher yield than the 2.85% which the 10-year Treasury currently yields. All things being equal, same coupon rate, same maturity, etc., the higher the yield, the lower the value of the bond. In this example a yield of 2.85% (2.75% coupon) produces an approximate value of $99.125. The yield of 4.06% on the same structure bond produces a bond value of approximately $89.25. In this example, if rates rise 1.20% to a 4.06%, the value of the bond drops approximately 10%.

It is generally believed the 35-year bull market in bonds ended in 2016. The opinion held by many is we are now entering a bear market which means higher yields. Higher yields translates into lower bond values. Whether we are entering a long-term bear market in bonds or just experiencing a yield adjustment in the near future varies as to anyone’s guess or opinion. However, most agree that trying to pick a bottom to begin investing is not a good idea.

So, how should an investor proceed in order to take advantage of higher interest rates but still be defensive in nature?

Interest rate risk is a valid concern as illustrated above. One way to control risk is addressing duration risk. One definition of duration is: “A calculation that portrays to the bond holder when their initial investment is returned in the form of all interest and principal cash flows.” The lower the duration, the less impact a change in interest rates has on the market value of a bond. As interest rates rise, traditional bond values go down; the longer the duration, the more dramatic the market value changes.

  • Two ways to help control duration are maturity and coupon size (premium bonds).
  • The shorter the maturity the shorter the time the investor gets their par value of the bond returned.
  • The higher the coupon, the quicker the original investment of the bond is returned to the investor to reinvest presumably at higher rates in a rising interest rate environment.
  • Below illustrates how duration impacts bond values in a rising interest rate environment.

The maturity of a bond impacts duration and market price as well. Take our 5% bond due in 10 years vs. a 5% bond due in five years and 20 years.

Coupon

Maturity

Duration

Market Value Loss 1% Rise in Rates

5%

5 years

4.20

(4.25%)

5%

10 years

7.85

(7.50%)

5%

20 years

12.75

(12%)

Source: AAM | For illustrative purposes only.

Knowing what you own and knowing that your bond investments have a stated maturity date in a rising interest environment is important, not only psychologically but in order to reinvest one’s principal in the current market environment.

Both knowing what you own and diversification can be achieved by owning individual bonds or by investing in an investment vehicle that allows the investor to own a share of a pool of non-managed known, individual bonds. The investor effectively owns a proportionate share of each bond in the pool.

Regarding rising interest rates, controlling duration is a major consideration. As always, consult your financial advisor before making investment decisions.

 

CRN: 2018-0205-6401 R

An investment in Municipal Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the municipal bond market, possible downgrades, changes to the tax status of the bonds and defaults of interest and/or principal. A bond’s call price could be less than the price paid for the bond. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bond insurance covers interest and principal payments when due and does not insure or guarantee the value of any bond in any way.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.

 

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