Over the past five years, volatile stock markets have triggered a massive shift from equities (i.e. stock investments) to bonds (including exchange traded bond funds (ETFs) and bond mutual funds) as investors have sought to reduce the level of risk in their portfolios. This move has driven bond prices higher and bond yields (i.e. the annual interest income received from a bond expressed as a percentage of its current value) lower.
Often overlooked by investors, investment grade bonds (which exclude guaranteed investments such as Canada Savings bonds) are interest rate sensitive. As a result when interest rates increase, their value drops and yield will rise (with the opposite occurring when interest rates fall). With interest rates at historical lows and a recovering economy (that is expected to result in an increase in inflation), a prolonged rise in interest rates (and corresponding decline in bond prices) seems inevitable. Unfortunately (according to a recent CSA survey), most Canadian investors do not understand how bonds work (most notably their risks). Without this knowledge many may suffer significant losses to their portfolios before they even realize what has happened.
When a bond is purchased, the buyer (or bondholder) is in effect lending money for a specific period of time to the borrower (or bond "issuer"). Under the terms of the bond the bondholder will receive the loan amount (the "face value" of the bond) at its maturity plus regular interest payments (as specified in the bond's "coupon"). What most investors fail to understand is that after a bond is issued it continues to trade in the open bond market where its price and yield will constantly change (both upwards and downwards) in order to stay in line with current interest rates. While falling rates will result in a bond appreciating in value (or selling at a "premium"), rising rates will lead to a bond declining in value (or selling at a "discount").
For instance, consider what happens to a bond having a value of $1,000 and a coupon rate of four per cent (i.e. it pays $40 in interest annually) when interest rates rise. Now an investor is able to purchase a similar bond having a five per cent coupon (i.e. it pays $50 annually). Since the coupon rate on a bond does not change, it is its price which must fall as the interest received is less than what a new investor would receive by purchasing a bond at the current rates. The amount by which a bond will drop in value is primarily determined by the bond's maturity (i.e. the longer the bond has to its maturity the greater the drop in value).
The standard means by which to estimate a bond's movement in response to a change in interest rates (i.e. its "interest rate risk") is "duration". Denoted in years, duration "takes into account a number of factors about a bond" (including its maturity). The higher the number, the greater the sensitivity of a bond to changes in interest rates. The general rule is that "for every +/- one per cent move in interest rates, a bond's price will move inversely (opposite) by a percentage equal to that of its duration". For instance, a bond with duration of six years will decrease in value by six per cent with a one per cent rise in interest rates (with the opposite happening in the case of an interest rate decline). The duration of bonds held within a mutual fund or ETF can readily be found in the fund's fact sheet or by checking the fund company's website. Free online calculators may be used to calculate the duration of an individual bond.
While there are many benefits to investing in bonds, investors need to understand how bonds work, their risks, and the investment strategies that can be employed to minimize the risks (interest rate risk, inflation risk, credit risk, etc.) Of utmost importance is the construction and regular rebalancing of a portfolio that is custom tailored to the individual risk tolerance and financial goals of the investor. The use of a financial professional is recommended.
Darryl Prociuk CFP, R.F.P., CLU, TEP is a Registered Financial Planner and may be contacted at [email protected]
