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Health & Fitness

Bond Fund Gyrations


People of modest means vastly outnumber those who have amassed sufficient capital to be ranked as financially independent. Those with small nest eggs often are counseled to take little risk because they cannot afford losses. That’s what one woman was told by a financial services firm over an 800 toll-free phone line. All of the funds in her portfolio were from that company. With retirement over 12 years away, she was heavily weighted in cash and bond. Equity-based funds were a small percentage. Risk comes in various forms, including interest rate sensitivity.

 

With a need to grow her capital base, she was underweighted in growth potential. She did not fathom how much risk she was taking in the pursuit of safety. Looking backward, her funds had good numbers and she saw bond funds as secure compared to a gyrating stock market. “Past performance is no guarantee of future performance” is a standard warning for those using historical numbers to pick investments. With two bear markets in stocks since 2000, wary investors poured money into bond funds. That worked well as the U.S. Federal Reserve Bank pushed interest rates to new lows. That trend has seen a rapid reversal.

 What happens as interest rates rise?  Suppose that you own a $1000 fixed rate government bond maturing in 15 years with a 4% coupon. You will receive $40 a year in interest.

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Suddenly you need your $1000 back; you cannot wait for 15 years for the bond to mature. You ask Mr. Market to sell your bond. You want $1000, but Mr. Market has a problem. Interest rates have risen and he can get a government bond with a 15 year maturity paying 5%, or $50 per year. Since he knows he can get 5% and your bond only yields 4%, he must adjust the price he will pay for your bond.

He divides your $40 yield by the new market interest rate ($40/.05=).  He will pay $800 to buy your bond. His $800 investment now yields 5% in line with current market rates; you lost 20% in value on a 1% (100 basis point) increase in interest rates. Many factors influence the pricing of a bond but this simple hypothetical example makes a powerful point. As interest rates rise, bond values decline.

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The yield on 10-year Treasury note is a key benchmark in bond pricing. Following the inflationary 1970s, ten-year Treasury rates peaked at 15.84% in September 1981. Interest rates go up and down but the long-term trend was down for over 30 years as bond values rose. In July, 2012, 10-year rates bottomed at a low of 1.390%. In recent gyrations, the 10-year benchmark rate jumped to 2.309% following Ben Bernanke’s remarks hinting at a reduction in the Federal Reserve’s easy-money policies. A rise of roughly 92 basis points is a big move in the bond world. With trillions of dollars stashed in bond funds, especially in retirement plans, investors must reassess the meaning of risk. Many do not understand interest rate risk.

 “Duration” is a measure of interest rate risk attached to a bond or bond fund, in simple terms indicating sensitivity to interest rate changes. One leading total bond market index fund found in many retirement plans holds roughly $117 billion in assets, 30% corporate bonds and 70% government bonds from short- to long-maturities; recent yield 1.58%. Seems safe? The fund has a duration of 5.5 years; a 1% increase in interest rates will drop the value of the fund by 5.5%.

 A widely held 5-star rated longer-term U.S. Government bond fund has a duration of over 8 years. A modest 1% upward move in interest rates will result in a 8% decrease in value. Investors are urged to look up the duration of funds they own, data available by typing “duration of XYZ fund” into a search engine or by checking sources like Morningstar.

 How do your holdings match your financial independence goals? Too much risk...or not enough?

 Lewis Walker is President of Walker Capital Management LLC. and Walker Capital Advisory Services, Inc., a Registered Investment Advisor (R.I.A.) Securities and certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA).  Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with the Walker Capital Companies.  3930 East Jones Bridge Road ▪ Suite 150 ▪ Norcross, GA 30092 ▪ 770-441-2603 ▪ lewisw@theinvestmentcoach.com

 

 

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