Ups and Downs of Interest Rate Risk
Among the challenges investors grapple with is interest rate risk — the risk that interest rate fluctuations will cause an investment’s value to change. You probably know this classic axiom of investing: When interest rates go up, bond prices go down, and vice versa. That’s interest rate risk in action.
Why should today’s investors care?
Consider the common scenario of retirees on fixed budgets who invest part of their savings “conservatively” in long-term government bond funds for two reasons:
- They want a dependable source of income.
- US government bonds are generally considered to carry very low credit risk, meaning reduced risk from default.
But long-term government bonds may not be as conservative as many investors think. Why? Because while these funds may carry close-to-zero credit risk, they have a lot of interest rate risk. The value of some long-term government bond funds could quickly drop, depending on how fast and high interest rates rise and where these rate increases occur along the maturity spectrum.
How can investors assess interest rate risk for bond funds?
Two key measures can help you gauge how much interest rate risk a fund is taking:
- Average maturity is a good place to start. A fund with a longer average maturity can be much more sensitive to interest rate changes than one with shorter-term maturities.
- An even better indicator is duration, a measure of the average price sensitivity of the fund’s bond holdings to changes in interest rates at a given point in time. Think “seesaw” as a visual analogy — the farther out you sit, the greater the seesaw’s sensitivity to motion. Likewise, the greater a fund’s duration, the more susceptible its net asset value is to changes in interest rates. For a fund with an average duration of five, for example, a 1% increase in the yields (interest rates) on the fund’s bond holdings would be expected to translate into approximately a 5% drop in the value of the fund, all else being equal.
- It is important to remember that a fund’s total return comprises price changes plus the coupon income generated from the fund’s holdings. Duration is a gauge to help investors understand how that price component will move, but the whole total return picture includes the income that is generated as well.
What strategies help investors manage interest rate risk?
In general, investors can mitigate interest rate risk by including investments with shorter maturities/durations or less sensitivity to changes in rates. For example:
- Products with shorter to intermediate average maturities and/or durations — such as short term, core plus, short- and intermediate-term munis, and bank loans — to help limit the negative effect of climbing rates on principal, while still providing current income.
- Products with bonds that generate additional income — such as select investment-grade corporate, emerging market and high-yield bonds — that can offset price volatility should interest rates rise.
- Products that diversify their holdings so that the yields on all the bonds don’t move in the same direction to the same degree at the same time.
All fixed-income securities are subject to two types of risk: credit risk and interest rate risk. Non-investment grade securities (junk bonds) have greater risk than investment grade securities including the possibility of default. Senior secured floating rate loans and debt securities that require collateral. There is a risk that the value of the collateral may not be sufficient to cover the amount owed. Securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Core-plus strategies invest the majority of their assets in securities found in broad-market, investment-grade indexes, and use the remainder of their assets to opportunistically pursue other fixed income asset classes to enhance total return and/or income.