Bonds and Interest Rates - What to do

The following illustration shows the relationship between bonds and interest rates. Think of it as a teeter totter. When one goes up the other goes down. Hence, when interest rates go down, bond prices will go up, and when interest rates go up, bond prices will go down.

Lower interest rates result in the appreciation of a bond mutual fund, but also lower interest income payments over time. As bonds mature the new bonds purchased pay a lower interest rate. Thus, there are two main factors at work here for investors; the value of the investment and income provided. Consequently, I want to discuss both of these items and how they may impact you.  

Average Effective Duration

Regarding the first (value of investment), there is a term called duration, which is used as a measurement of how a bond fund's price will be impacted by interest rate changes. Average effective duration provides a measure of a bond fund’s interest-rate sensitivity. It is kind of like our thermometer in assessing how a bond fund will be affected by interest rate changes. 

The longer a fund’s duration, the more sensitive the fund is to shifts in interest rates. 

The relationship among funds with different durations is straightforward: A fund with duration of 10 years is expected to be twice as volatile as a fund with a five-year duration. 

Duration also gives an indication of how a fund’s net asset value (NAV), or what most of us refer to as price per share, will change as interest rates change. A fund with a five-year duration would be expected to lose 5% of its NAV if interest rates rose by 1 percentage point, or gain 5% if interest rates fell by 1 percentage point. 

Since we are probably facing higher interest rates going forward, duration is a measurement that we consider quite important. For that reason, we want to be selective and own funds that have lower average effective durations of say six or below versus funds with durations of say 15 or more. This is important because interest rates have begun creeping up. As a result, a fund with duration of 15 would see its net asset value (NAV) drop 15% or 2.5 times that of a fund with a duration of six. So in this regard, currently we are focusing on funds with what we consider lower average effective durations (AVEs). Ideally, we try and select funds with AVEs under four. I would rather have more downside protection against higher interest rates in the future, than reaching for more interest income today. 

Income

As the prior illustration shows, interest rates and bonds have an inverse relationship. As a result, when you own a bond mutual fund, this can cause it to self-regulate. If interest rates go down over time, then you'll see your fund go up in value, but you'll also be receiving less income. On the other hand, if interest rates go up, then you see the price per share of your bond fund go down in value, but over time you'll start receiving more income. 

Hence, over a period of time (i.e., several years), bond funds will adjust for interest rate changes. The prospects of a lower price per share can be less painful when you begin to see higher payouts. Thus, for investors needing income, higher interest rates aren't necessarily a horrible thing. It could sting at the beginning, but for those who can ride it out, more income will be a welcome change. Also, for those investors who are reinvesting their earnings, a higher income and lower price per share lets you reinvest and purchase more fund shares, which over time should provide you with greater income. Either way, more income may be in the offing.


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