Reason #1 – Duration Risk Due Diligence
We’ve all heard the news about recent rate hikes at the US Fed and talk of subsequent rate hikes in the months ahead. Many investors may be asking themselves – interest rate hikes of 25 basis points? 0.25%? What’s the big deal? But remember, the Fed has raised rates seven times (or 1.75%) since the end of 2015. Interest rates and bond prices have an inverse relationship – when interest rates increase, bond prices decrease. Likewise, the longer a bond’s duration, the greater its potential exposure to increasing interest rates – also known as “duration risk.” A 1% interest rate increase effects bonds of different durations very differently. As the below graph depicts, short duration bonds may offer investors protection from rising rates.
Reason #2 – Markowitz Math
In 1952, American economist Harry Markowitz formulated the “efficient frontier.” He acknowledged that there are no risk free assets, but a portfolio can be considered “efficient” if it has the best possible expected level of return relative to its level of risk.
As the chart below demonstrates, in the current interest rate environment, long and intermediate term bond holdings are less efficient in terms of risk-adjusted yield – a measurement of yield that accounts for the discount or premium at which a bond is purchased. Here, efficiency is measured by a 1% or greater risk adjusted yield.
Reason #3 – Value Judgements
Another way to compare fixed income allocations is by considering yield per unit of duration risk. In bond terminology, this translates to “bang to buck ratio.” In the current market environment, short-term bonds offer strong yield per unit of duration risk, or yield dividend by duration. This is because shorter duration fixed income investments are by nature less exposed to the potential negative effects of any interest rate increases that occur over time.
In any market environment, it is important for investors and financial professionals to consider their financial goals and risk tolerance. In a rising rates environment, short-term bond allocations have the potential to provide portfolios increased efficiency, value potential, and risk management.
Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity. Duration risk measures a bond's price sensitivity to interest rate changes. Bond funds and individual bonds with a longer duration (a measure of the expected life of a security) tend to be more sensitive to changes in interest rates, usually making them more volatile than securities with shorter durations.
Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.
All investing involves risk including the risk of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.