Beware of Safe Investments: The Hidden Risk in US Government Bonds
After what some have called a 30 year rally in US Treasuries, many investors have come to look at investments in US Government bonds as safe. During the 2008 market upheaval and right after the “Flash Crash” on May 6, 2010, yields plummeted on all government bonds when investors piled into these safe investments.
Because of the decline in bond yields and increase in prices, it may be that intermediate and long-term bond prices have nowhere to go but down, or at best stay flat. While the picture may change investors have to be cautious about holdings in intermediate and long term bonds, especially US Government Bond mutual funds.
How are bonds impacted by rising interest rates? Here is a simple example of why interest rates are important. Let's say an investor, we will call him Joe Smith, holds of a bond with a yield of 2.5%. Every year his $1,000 bond pays $25 in interest. If Joe holds this bond until it matures, we know he will make 2.5% per year on the bond.
But Joe needs to sell the bond. Since Joe bought the bond, interest rates have risen to 3.5% for an otherwise identical bond. Joe has to sell his bond, but a prospective buyer can buy a similar bond that will pay him $35 per year in interest, instead of $25. Joe is a nice guy, but why would a buyer purchase Joe’s bond that pays 1% less interest per year? He or she wouldn't. If Joe Smith wants to sell his 2.5% bond, he will have to discount the bond. That means he will have to reduce the price so the prospective buyer will get the 3.5% yield.
To help understand the risk in a bond or a portfolio of bonds (like a bond mutual fund) there is a helpful tool, duration. Duration is a common measure of interest rate risk in bonds. While it may be helpful to understand the theory of duration, it’s more important to understand how to use the duration information. The fact sheet or prospectuses for most bond mutual funds or ETFs will have the duration prominently listed.
With this duration number we can get some idea of how a portfolio may behave in different interest rate environments. A bond portfolio of long maturity US Treasury bonds may have a duration of 10, 11 or higher. The higher the number the more the risk (a 30 year zero coupon bond has a duration of 30). How does duration help us understand the sensitivity to interest rates?
There is a rule of thumb that helps us apply the concept of duration to understand rising interest rate's affect on a bond or portfolio of bonds. This rule of thumb provides that if interest rates go up or down by X% … one only needs to multiply the change in interest rates by the duration of the bond or portfolio of bonds to see how the market value of the portfolio will change.
For example if interest rates go up 1% and a bond or bond fund has a duration of 6, the value of the bond portfolio should go down by about 6% (1% multiplied by the duration of 6). So using our rule of thumb, a 1% increase in rates should cause the portfolios of US Treasury bonds with a duration of 10, 11 or higher to go down 10%, 11%, or more. For that 30 year zero coupon bond, the 1% interest rate rise could cause its market value to decline by 30%.
Bond mutual funds could be more risky than individual bonds, because of panic selling by some holders, which could lead to realized losses for all holders.
If we look back into recent history, the Fourth Quarter of 2010 was a disappointment for investors with large holdings in intermediate and long-term Treasury bonds. Interest rates on 10 year Treasuries saw a near 1% rise in yields in just a few weeks, and that was in the face of the Fed’s commitment to purchase Treasuries (aka quantitative easing or QE2), which many thought would have the opposite effect. Since bond prices go down when yields go up and vice versa, many investors in US Government bonds found that they lost money in investments they thought were safe.
No one knows for sure where bond prices are going from here. There is room for some bonds to go up, but you should be aware of the risks.
How can a bond investor reduce risk and still get some return? One approach would be to diversify away from duration risk with shorter duration bond funds and ETFs. While short-term bond funds may lose some value if interest rates rise (certainly not as much as longer-term bonds), the short-term bond funds should reset to higher yields more quickly; this is because the bonds mature more quickly and new bonds are purchased at a higher yield. When paired with cash (money market funds) or a cash ladder, the investor may be able to secure a reasonable short-term yield, while having a firewall to protect against significant declines due to interest rate rises.
Where duration risk is taken, the investor should consider diversifying the risk among funds. Carefully selected, best-in-class actively managed bond funds should have a better chance of anticipating and adjusting to a changing interest rate environment than bond index funds.
We continue to believe there is a risk of significant decline in bond prices (increasing yields), especially US Treasuries, should interest rates rise. We saw that happen in 2009, when the US Treasury market declined. We readily admit we have no idea when or if an interest rate rise will occur, but avoiding large bets in higher duration bonds (higher interest rate risk) could be a prudent approach. A 1% increase in yield is not worth the 3-4% of additional downside (duration) risk that accompanies that yield.
Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author but not necessarily those of the Third Sigma Investment Advisors LLC. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. All investments carry risk and may lose value. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Third Sigma Investment Advisors LLC. ©2012.