Interest rates are near all-time lows. Consequently, whenever rates finally start moving again, we all know they’ll be going up. No one knows for sure when rates will begin to rise, but the Financial Industry Regulatory Authority must be worrying that the day isn’t far off. It’s just released an Investor Alert entitled “Duration – What an Interest Rate Hike Could Do to Your Bond Portfolio.” You can read the entire alert here.
When interest rates rise, bond prices fall. This phenomenon is known as interest rate risk. But FINRA points out that it’s not enough for bond investors to understand interest rate risk. They should also be wary of “duration risk” – i.e., the risk associated with the sensitivity of a bond’s price to a one-percent change in interest rates. (Bond fund investors can find measures of duration in the fund’s fact sheet, while holders of individual bonds can check with their brokers or the bond’s issuer, or search the web for an online calculator to get the figure.)
The higher a bond’s duration, the more dramatically the bond’s price will be affected by rate changes. To illustrate, FINRA compares two medium investment grade corporate bonds, one with a duration of 8.4 (10-year maturity, 3.5% coupon) and the other with a duration of 14.5 (30-year maturity, 4.5% coupon.) With a 2% rise in interest rates, the first bond could drop 15% in value while the second could drop 26% due to its greater duration. FINRA notes that the same effect occurs with bond funds, meaning that a fund with a duration of 10 would lose 10% of its value for each 1% increase in interest rates.
We don’t give investment advice. If you want on-line prognostication, you can Google “bond bubble” and see plenty of opinions. But we feel pretty safe in suggesting that interest rates won’t stay this low forever. If you have big positions in bonds, particularly bonds with high durations, your broker probably should already have at least discussed with you the concept of limiting your exposure. If your broker hasn’t mentioned anything, you might want to think about asking.
Hugh Berkson is a Securities Attorney with McCarthy, Lebit, Crystal & Liffman, Co. LPA. Hugh is rated AV® Preeminent™ by Martindale-Hubbell®.
He obtained a business degree in Finance from the University of Texas at Austin in 1989, and is a 1994 graduate of Case Western Reserve University School of Law, where he was a member of the Order of the Barristers and received both the American Jurisprudence Award, (National Mock Trial) in 1993 and the Jonathan M. Ault Mock Trial Prize for 1993-1994.