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Today investors find themselves at a point where bonds have rallied for the last several decades, which has pushed interest rates well below historical averages. With the Fed currently at the helm directing rates, investors should be careful regarding future moves but there may be signs yields are putting in a bottom.

NOTE: Yields are estimated on left and right scale by placing a decimal after the first digit.

While both interest rates and inflation are well below historical averages, interest rates are much further below. This difference provides a potential target for higher interest rates if the Fed exits the bond market.

What long-bond investors need to understand is the values of their bonds are going to be negatively impacted when yields rise. A bond's duration provides a simple way to estimate the impact of rising interest rates on a bond's price. A bond with duration of 10 will see its price decline by approximately 10% for every 1% rise in interest rates. A bond with duration of 7 will see its price decline by approximately 7% for every 1% rise in rates. The opposite is true, falling interest rates push bond prices higher. Using the iShares 20+ Year Treasury Bond ETF as an example, the current Effective Duration is listed at 17.15. A 2% rise in interest rates could send this bond ETFs price down by approximately +30%. There are different calculations for duration and it changes but the higher the duration the more sensitive a bond investment is to changes in interest rates.

I am not sounding the alarm but for those investors who have gone out on the yield curve for income, and a lot of money has flowed to bond funds since 2008, be aware of the impact rising interest rates will have on your investments value. Given where we are with rates and recent signaling by the Fed, there may be a reasonable case for harvesting some gains and reinvesting in lower duration bonds with part of the proceeds; using capital gains to replace interest income.

Here is a list of bond ETF's with their Distribution Yield1, Effective Duration2 and Monthly Two Standard Deviation Return Range3.

ETF Name (Symbol)

Yield1

Duration2

Monthly Standard Deviation3

iShares Barclays Long-Term Treasury (TLT)

2.59%

17.15

-7.3% to +8.7%

iShares Barclays TIPS (TIP)

0.08%

8.054

-3.2% to +4.2%

iShares Barclays 7-10 Yr. Treasury (IEF)

1.65%

7.52

-3.5% to +4.5%

iShares iBoxx Invest Grade Bond (LQD)

3.53%

7.75

-4.2% to +5.2%

iShares S&P National Muni Bond (MUB)

2.63%

6.1

-3.1% to +4.0%

iShares Core Total US Bond (AGG)

2.44%

4.6

-1.9% to +2.7%

iShares iBoxx High-Yield Corp Bond (HYG)

6.39%

3.98

-8.3% to +9.5%

NOTES: Distribution Yield and Effective Duration from iShares. Monthly Two Standard Deviation Return Range from ETFReplay.com.

1. Annualized yield of most recent payout

2. A measure of potential responsiveness of a bond portfolio to small parallel shifts in interest rates

3. If monthly returns were normally distributed, 95% of monthly returns would be within this range

4. Real Yield Duration is based on shifts in real yields versus nominal yields

Bond investors who want to protect the value of their bonds, or take advantage of the change in market character, will need to deploy a different set of tools when interest rates start marching higher. Some options include: Sell intermediate and long-term bonds and reinvest in short-term or lower duration bonds, and "short bonds" (i.e. make money if bond prices fall). There are ETFs that allow individual investors to "short bonds" but they are tricky investment vehicles and best left to experts. A better option for many investors might be to hold shorter-term (lower duration) bonds, floating rate bonds, and some junk bonds.

It's the Fed's participation in the bond market that has created the current dilemma. Do investors think 10 & 30 year rates would be at current levels if the Fed were not actively buying bonds? There is little question Fed participation in the bond market has sent bond prices higher and rates lower. However, if the economy falls back into a recession we can expect the Fed to remain active in the bond market and keep rates close to where they are today.

An easy way to think about the current interest rate environment might be to acknowledge that intermediate and long-term rates are around 55% below historical averages. I came to this number by using the CITI Treasury/Agy 10+ Year historical average yield of 5.5% and subtracting and evenly weighted average of the current 10 & 30 year Treasury yield as listed on Bloomberg which I calculate as 2.52%. In terms of inflation, I used a historical rate of 3% and a current rate of 2%. Based on these measurements, intermediate and long-term bond rates may rise a full percent and still be 30% below their historical averages and on par with the current inflation rate relative to its historical average. This is a very simple example and the analysis of interest rates, inflation and bond prices is complex. There are many different possible rate sources but those uses were readily available.

  • Inflation's approximate current discount from historical average = 30%
  • CITI Treasury/Agy 10+ Year historical average discounted by 30% = 3.85%
  • Bloomberg Treasury 10 & 30 Year Equal Weight Current Yield Average = 2.52%
  • 3.85% - 2.52% = 1.33% (Potential increase in bond interest rates and still remain 30% below historical average.)

For a bond investment with duration of 10, you could expect the price to decline by approximately 13% if rate rose under this scenario. This is probably not something the average bond investor is expecting, especially if they are drawing income from their investments.

It is interesting that on January 3, 2013 Fed officials reported they are "evenly divided" regarding whether to end QE mid-year or continue through the balance of 2013. Future interest rates and Fed policy likely hinges on the economy. If we maintain a slow growth environment but avoid another recession there appears a reasonably good chance rates will rise for bonds and still remain well below historical averages. If we slip into a recession we will likely find rates at current levels, perhaps even lower. If the economy shifts into a higher gear we could see rates and inflation move well past historical averages. If that happens a high duration bond holder may feel like a stock holder during a brutal market crash. If you want to try and avoid that scenario keep an eye on the economy, Fed policy, and interest rates as we move into 2013.

Source: Estimating Bond Interest Rates Without Fed Buying