Interest Rates vs Bonds
Last year we saw carnage across multiple asset classes. Both stocks and bonds were beaten down relentlessly in an environment of rising interest rates. Today we discuss why bonds are affected by interest rates and how duration can be used to measure their sensitivity.
Bonds have a negative correlation with interest rates. Imagine you pay $1,000 dollars for a 10 year bond. Let’s also say it has 4% coupon rate. A couple months later interest rates rise so newly issued 10 year bonds pay 5% coupon rate. Why would someone pay $1,000 for your bond when they can spend that same money to buy a new bond that pays more? You would have to sell your bond below face value to keep it competitive with new bonds. Conversely if interest rates fall to 3% your 4% bond may be sold for a premium.
Furthermore, longer maturity bonds are hurt (or helped) more by changes in the interest rate. A thirteen week T-Bill is fairly resistant to changes in interest rates. The bond matures in a relative short span allowing you to reinvest faster. In the example above the 10 year bond is a longer commitment.
What is Duration?
Duration is a way to quantify a bond’s sensitivity to changes in interest rates. A lower duration means less change, both to the upside and the down. Duration should be considered alongside the negative correlation to interest rates. If you expect interest rate to rise you would look for bonds or funds with low duration to better protect yourself against downside movements, alternatively in an environment of falling interest rates you could look for a longer duration to take advantage of some potential moves to the upside.
If you have found this post helpful you can click below to schedule a free investment consultation and see how our insights can work for your portfolio and investment objectives.
