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The great hockey player Wayne Gretzky is credited with two famous quotes that have been repeated by Warren Buffett:

A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.

I skate to where the puck is going to be, not where it has been.

This is very sound advice. Good investors build portfolios based on today's economic circumstances. Great investors build portfolios based on where they see economic circumstances moving in the future. Ah, but therein lies the rub -where are we moving to? Get a room full of economists together; ask them to predict the future and you will get a room full of different prognostications.

One seeming simple question is: where are interest rates headed and when? Fed Chairman Bernanke has made it very clear his intention on keeping rates low until the unemployment rate is at 6.5% or lower and inflation remains below 2.5%. However, the timeframe for achieving either a) a 6.5% unemployment rate or b) inflation rate higher than 2.5% is clouded at best.

With interest rates at historic lows, there should be a higher probability that rates will eventually increase than not. If this assumption is used, one could determine the impact of rising rates on the market value of bond investments. The math is pretty easy -- as bond yields rise, bonds trading in secondary markets and bond mutual funds in general will decline in value. The decline will depend on maturity date and credit quality, with longer maturities and lower credit quality usually declining the most. Bonds should trade in comparable historic ranges as specific interest rates are realized.

The table below outlines the price impact in the secondary market as a percentage change in interest rates:

U.S. Treasuries

-1.0%

+1.0%

Average Maturity Years

2-yr

2.0%

-2.0%

2.0

5-yr

4.9

-4.9

5.0

10-yr

8.9

-8.9

10.0

30-yr

19.5

-19.6

30.0

MBS

2.9

-2.9

4.9

High Yld

4.2

-4.2

6.7

TIPS

4.2

-4.2

9.3

Broad Market

4.9

-5.0

7.1

Emerging Market

6.4

-6.4

11.1

Corporate

6.9

-6.9

10.5

Munis

8.1

-8.1

13.5

Source: JP Morgan

This table offers a road map as to what historically happens with bond prices as rates rise and fall. It is not coincident that prices in the secondary market move the same percentage regardless of the direction. The table also offers a comparative price movement based on types of bond at various maturities.

According to the table above, for every 1.0% increase in 30-year bond rate the price of those bonds in the secondary market will decline by 19.6%. In addition, municipal bonds with an average of 13.5-year maturity will decline by 8.1% for every 1.0% rise in rates. The table also allows for comparisons of various types of bonds with approximately the same maturity. For example, for every 1.0% rate rise, 10-year Treasuries should decline by 8.9%, 10.5-year Corporates should decline by 6.9%, 11.1-year Emerging Markets should decline by 6.4%, and 9.3-yr TIPS should decline by 4.2%. Within this framework, TIPS with approximately 10-year maturities would offer the better comparable retention of capital in an increasing interest rate environment.

This movement in bond prices to changes in interest rates is also known as the "duration", not to be confused with the maturity date or the date the principal is due to be repaid to the investor.

From Investopedia definition of duration:

A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. The duration number is a complicated calculation involving present value, yield, coupon, final maturity and call features. Fortunately, for investors, this indicator is a standard data point provided in the presentation of comprehensive bond and bond mutual fund information. The bigger the duration number, the greater the interest-rate risk or reward for bond prices.

It is a common misconception among non-professional investors that bonds and bond funds are risk free. They are not. Investors need to be aware of two main risks that can affect a bond's investment value: credit risk (default) and interest rate risk (rate fluctuations). The duration indicator addresses the latter issue.

The duration is usually reported in Morningstar.com bond fund recap on their first page.

Reviewing the duration, maturity, and current yield for a few of the more popular bond funds and bond ETFs would create the following table: (MUTF:PTTDX), (MUTF:FTBFX), (MUTF:MWTRX), (NYSEARCA:BND), (MUTF:PRHYX), (MUTF:PREMX), (NYSEARCA:ELD), (NYSEARCA:AUD), (NYSEARCA:BSCF), (NYSEARCA:STIP), (NYSEARCA:STPZ), (NYSEARCA:TIPZ), (NYSEARCA:SCHP), (MUTF:VUSTX), (NYSEARCA:EDV):

Fund/ETF

Ticker

Duration

Maturity Years

Current Yield

Pimco Total Return

PTTDX

4.02

5.9

3.42%

Fidelity Total Return

FTBFX

4.74

NA Intermed

3.07%

Metro West Total Return

MWTRX

3.87

6.6

3.72%

Vanguard Total Market

BND

4.97

6.9

2.79%

T Rowe High Yield

PRHYX

3.44

6.5

6.90%

Bulletshares 2015 High Yld

BSJF

2.60

4.4

5.21%

T Rowe Emerging Market

PREMX

6.44

11.5

5.74%

WisdomTree Emerging Market

ELD

4.76

NA Intermed

3.28%

Pimco Australia

AUD

4.07

4.8

3.26%

Bulletshares 2015 Corp

BSCF

2.53

2.6

2.14%

iShares TIPS 0-5 yrs

STIP

2.17

NA Short

0.96%

Pimco TIPS 1-5 yrs

STPZ

2.17

2.9

0.94%

Pimco Broad Base TIPS

TIPZ

6.50

9.7

1.44%

Schwab US TIPS

SCHP

8.16

9.2

1.25%

Vanguard Long Term Treasury

VUSTX

15.39

NA Long

2.57%

Vanguard Extended Duration

EDV

26.36

24.5

2.82%

Source: Morningstar.com

Within bond fund and bond ETF classifications, comparing duration calculations will allow investors to analyze their specific bond fund/ETF investment's interest rate risk. As always with investing, there are tradeoffs and with bonds, the choices lie between lower duration, shorter maturities, and higher current yield.

Morningstar recently interviewed BlackRock's Rick Rieder, chief investment officer of fixed-income fundamental portfolios and portfolio manager of BlackRock Total Return and Strategic Income Opportunities. His comments concerning duration are below:

"The only thing that I do believe in that's different now is I do think that with fixed income--because you are getting issuance, low coupon debt being issued, low coupon Treasuries, low coupon mortgage--duration, or the risk of fixed income, is actually growing now. In addition, maybe a little bit of inflation comes in now because you are starting to get credit creation to pick up again. I think we will still be in a low-rate environment. I think that the fixed-income market is becoming more sensitive to interest rates now than it has certainly in the last three or four years. I think it's being sensitive to potential duration risk, or interest-rate risk, being more flexible in your portfolio to move around, so you are not counting on the last 20 years--and not in a straight line, but interest rates have come straight down for 20 years to where we are today. We are not going to keep going that way. So it stays here, maybe drifts up a little bit.

I think the one thing that does not get as much play as it should is that this duration risk is now building. In addition, I do not think rates are going to move higher, but I think people will be surprised particularly in longer interest-rate risk, 30-year Treasuries. I was describing it the other day, you take the volatility of 30-year Treasuries, it doesn't take much to blow your entire annual yield. I mean, literally, if you had a 15-basis-point rise in interest rates in 30-year Treasuries, your whole annual yield is gone because now it gives a long duration. I think because we have been in a low-rate environment, because the Fed's been doing what they are doing, there is a natural tendency not to think that broad rates could go up again. I do not think they are moving significantly, but I do think longer-term interest rates, if inflation picks up, could move up, and the sensitivity is higher that I think people need to be cognizant of that entering portfolios."

How soon will rates go up and by how much? Most crystal balls inaccurately answer these questions and whenever the Magic 8 Ball is asked, the answer is the same, "Ask Again Later". This time of year, many market observers offer their prognostication and it would behoove investors to pay close attention. For example, MetLife (NYSE:MET) recently offered their 2013 earnings guidance on page 19 of the year-end conference call. Metlife expects 10-yr Treasury yield to increase from its current 1.65% to 2.38% in 2013. The Royal Bank of Canada (NYSE:RBC) recently offered their 2013 forecast (pdf), which expects 10-yr Treasuries to also increase to 2.40% next year. In addition, RBC expects the yield curve to steepen with the 10s-2s calculation moving from a current 145 to 195 next year. The steepening of the yield curve will put added pressure on longer rates to move higher. Barron's recently published their guru's 2013 Forecast article and the average for the 10-year rate forecast by the ten individuals interviewed was 2.11%.

What if 10-year rates increase to 2.4% next year and how will it affect bond fund valuations? 10-year rates were about 2.4% in March 2012, Oct 2011, and Aug 2011. Taking a few of the funds/ETFs listed above, the following table outlines the current price along with the lowest weekly close price for each of these months:

Fund/ETF

Ticker

Duration

Current Yield

Price 12/18/12

Price 3/12

Price 10/11

Price 8/11

Pimco Total Return

PTTDX

4.02

3.42%

$ 11.33

$ 11.05

$ 10.69

$10.97

T Rowe High Yield

PRHYX

3.44

6.90%

$ 6.98

$ 6.74

$ 6.13

$ 6.40

WisdomTree Emerging

ELD

4.76

3.28%

$ 53.48

$ 51.92

$ 49.79

$53.42

Bulletshares 2015 Corp

BSCF

2.53

2.14%

$ 21.80

$ 21.49

$ 20.77

$21.32

Pimco TIPS 1-5 yrs

STPZ

2.17

0.94%

$ 54.00

$ 53.99

$ 53.09

$53.32

Schwab US TIPS

SCHP

8.16

1.25%

$ 58.40

$ 55.85

$ 54.07

$54.16

Vanguard Extended Duration

EDV

26.36

2.82%

$121.16

$107.31

$108.67

$93.90

It is not hard to see where the risk lies in the above list. If bond fund/ETF prices retreat to the lowest levels in the above table, the loss of capital from today would range from -1.24% for the Pimco TIPS to -22.5% for Vanguard Extended Duration. In all cases, the loss of capital would be higher than the current yield.

It is easy to duplicate the above tables for your own bond portfolio and the information is readily available online. If we assume the interest rate "puck" will be rising and we want to skate to where it will be, understanding the current risk to capital in bond funds and ETFs is the best first step.

Author's Note: Please review important disclaimer in author's profile.

Source: Is Your Bond Portfolio Skating With The Puck Or Skating To Where The Puck Will Be?