If you are thinking about buying bonds, or have recently bought some, you need to be aware of the effect of rising rates on your holdings.
Here are some questions you should consider. Interest rates, which recently hovered at their lowest levels in 40 years, are rising.
Just as bond prices go up when yields go down, the prices of bonds you own now will generally drop as yields—interest rates—go up. No, changes in interest rates don't affect all bonds equally. Generally speaking, the longer the bond's maturity, for example a bond that matures in ten years versus another that matures in two years, the more it's affected by changing interest rates.
A ten year bond will usually lose more of its value if rates go up than the two year note. Also, the lower a bond's "coupon" rate, the more sensitive the bond's price is to changes in interest rates. Other features can have an effect as well.
For example, a variable rate bond probably won't lose as much value as a fixed rate security. If you buy a bond and hold onto it until it matures, which many investors do, rising rates won't have any effect on the income you receive.
You simply redeem your maturing bond and get back par, or the face value, of the bond. In the meantime, you will continue to earn or accrue interest at the rate you expected when you bought the bond.
The second relates to the price of the bond as it trades in the secondary market. On the other hand, when the bond price is lower than its face value, it is said to be trading at a discount to par. But for those looking to sell their securities sooner, an understanding of what drives secondary market performance is essential. The price of a bond relative to yield is key to understanding how a bond is valued. Essentially, the price of a bond goes up and down depending on the value of the income provided by its coupon payments relative to broader interest rates.
In this situation, the bond price drops to compensate for the less attractive yield. Apart from interest rate movements, there are three other key factors that can affect the performance of a bond: market conditions, the age of a bond and its rating.
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Recipient Email Address Please enter valid address Email address is required. My Account Manage Subscriptions. Next Topic Download Resources Continue. Investment professionals rely on duration because it rolls up several bond characteristics such as maturity date, coupon payments, etc. Duration is expressed in terms of years, but it is not the same thing as a bond's maturity date.
That said, the maturity date of a bond is one of the key components in figuring duration, as is the bond's coupon rate. In the case of a zero-coupon bond, the bond's remaining time to its maturity date is equal to its duration. When a coupon is added to the bond, however, the bond's duration number will always be less than the maturity date. The larger the coupon, the shorter the duration number becomes.
Generally, bonds with long maturities and low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations.
Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment. Why is this so? Because bonds with shorter maturities return investors' principal more quickly than long-term bonds do.
Therefore, they carry less long-term risk because the principal is returned, and can be reinvested, earlier. Of course, duration works both ways. If interest rates were to fall, the value of a bond with a longer duration would rise more than a bond with a shorter duration.
Keep in mind that while duration may provide a good estimate of the potential price impact of small and sudden changes in interest rates, it may be less effective for assessing the impact of large changes in rates. This is because the relationship between bond prices and bond yields is not linear but convex—it follows the line "Yield 2" in the diagram below.
This differential between the linear duration measure and the actual price change is a measure of convexity—shown in the diagram as the space between the blue line Yield 1 and the red line Yield 2. The impact of convexity is also more pronounced in long-duration bonds with small coupons—something known as "positive convexity," meaning it will act to reinforce or magnify the price volatility measure indicated by duration as discussed earlier. Keep in mind that duration is just one consideration when assessing risks related to your fixed income portfolio.
Credit risk, inflation risk, liquidity risk, and call risk are other relevant variables that should be part of your overall analysis and research when choosing your investments. Log in to your Fidelity account to get specific bond data using the tools and features outlined below. Not a customer? Take a test drive by signing up for Guest Access.
Plot the duration of your fixed income holdings using Fidelity's Guided Portfolio Summary SM GPS to see at a glance the weighted average duration of your fixed income holdings at Fidelity.
The duration of your fixed income investments is also plotted on a grid in comparison to the benchmark. View duration in the Fixed Income Analysis tool to see the duration of your bonds, CDs, and bond funds.
Also, model the hypothetical addition to your portfolio of new bonds to see how they might impact the duration of the overall portfolio.
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