It’s one thing for financial advisors to warn investors about the pending increase in interest rates and the impact on bond portfolios. But it is a totally different matter when regulators start sounding the same alarm.
“With interest rates hovering near all-time lows, investors should make sure they know their duration numbers," said Gerri Walsh, vice president of investor education for the Financial Industry Regulatory Authority. "Whether investors own individual bonds or bond funds, they need to understand that outstanding bonds with a low interest rate and high duration may experience significant price drops if rates rise.”
There has been much discussion about the so-called “Great Rotation” as money is expected to flow from bond investments into stocks. The recent rally in equities to near all-time highs is evidence many investors have given up trying to find adequate interest rates in bonds and time certificates and have moved their attention to stocks, in particular, dividend-paying stocks.
“In our view, the pace of economic growth is likely to remain sluggish due to ongoing de-leveraging and weak income growth in the consumer sector, along with headwinds from tighter fiscal policy domestically and the recession in Europe," said Kathy Jones, co-author of a report from the Schwab Center for Investment research. "However, with yields so low in the fixed income market, the risks in long-term bonds are rising. Even a small increase in rates could send bond and bond fund prices lower, causing investors who sell to incur losses.”
The amount of risk associated with bond investments now is directly related to duration — the length of time to when the investment matures.
As an example, a Consumer Alert from FINRA explains a bond fund with a 10-year duration will decrease in value by 10 percent if interest rates rise one percent. In contrast, if a fund’s duration is two years, then a similar one percent rise in interest rates will result only in a two percent decline in the bond fund’s value.
The Federal Reserve has repeatedly suggested interest rates will not be heading up any time soon. However, the Fed controls only the shortest end of the interest rate spectrum and longer maturity bond rates are determined by the marketplace.
But, at the same time, investors who wait for the Fed to start raising rates as the economy improves and inflation starts to surface may be too late to avoid the possibility of declining values in their bond portfolios.
“Based on our analyses, interest rates have historically moved up on average of seven months ahead of the Fed’s tightening move. Therefore, we continue to suggest keeping portfolio duration in the short to intermediate range and emphasizing high quality credit over long maturity Treasuries,” said Fidelity’s Jones.
One thing is sure: interest rates have little room to decline below current levels. Sometime, possibly sooner than later, the move of least resistance will be for rates to move higher. For people who have been more concerned about the return of their money than the return on their money — and assumed bonds were safer than stocks — there could be a rude and expensive awakening.
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