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Ok so maybe I'm being a little melodramatic but I do have a point to make. The point is that bonds are not necessarily as safe as many investors may think they are. Most people think that bonds are a safe investment. To some extent they are correct, but they are not without risk. At the current low level of interest rates, there is a significant risk to a decline in bond prices that could burst the bubble of the bond rally we've experienced for the last 10+ years.

It is well known that the Federal Reserve has been deflating interest rates to help improve the economy, housing and unemployment. To do this the Fed has been buying MBS, U.S. Treasury Bonds and other debt instruments to the tune most recently of $85 Billion per month. Over the last 2 years the Fed's Balance Sheet has swollen to over $3 trillion and by the end of 2013 is expected to be over $4 trillion. It now owns around $1.8 trillion U.S. Treasury bonds and over $1 trillion in MBS. At the same time, investors have been pouring money into bond funds to the tune of over $2 trillion in fund flows.

So the big debate is, what happens when the Fed stops buying bonds and how does it unwind what it already owns? What is its exit strategy and can it do so without major disruption to the financial markets?

To review, the Fed has stated that it will continue to buy long-term assets (bonds) until the unemployment rate reaches 6.5%. It is assumed that this will occur sometime in 2014. Currently, the 10-year U.S. Bond yields about 1.95% and a 20-year bond about 2.8%. What would happen to the prices of those bonds and others if rates were to rise?

Remember from Fixed Income 101 that bond prices face risks too, consisting of interest rate risk, credit/default risk, reinvestment risk, market risk and inflation risk among others. The Fed attempts to control interest rate risk by its maneuvers to influence short-term rates. It has also embarked on manipulating long-term rates through its various iterations of Quantitative Easing the last 2+ years (QE1, QE2, QE forever … ).

What many non-professional investors may not realize is what the impact of rising rates would be on the prices of various bonds. Since U.S. Treasury Bonds theoretically are considered riskless securities (very low credit risk) it is easiest to demonstrate the impact of rising rates on the prices of these securities. Corporate and Municipal bonds also face credit risk and therefore trade at a spread to treasuries.

Below is a simple table looking at the potential impact of a 1% and 2% increase in interest rates from current levels on the price of par-priced (Par = $1000) Treasury bonds of varying maturities.

Table -1 U.S. Treasury Bond Assumptions:

US TREASURY BONDS

2-yr

2-yr

5-yr

5-yr

10-yr

10-yr

20-yr

20-yr

30-yr

30-yr

Future Bond Price

98.031

96.110

95.232

90.716

91.416

83.649

86.018

74.360

83.033

69.783

Maturity

3/1/2015

3/1/2015

3/1/2018

3/1/2018

3/1/2023

3/1/2023

3/1/2033

3/1/2033

3/1/2043

3/1/2043

Settle date

3/1/2013

3/1/2013

3/1/2013

3/1/2013

3/1/2013

3/1/2013

3/1/2013

3/1/2013

3/1/2013

3/1/2013

Today Bond Price

100

100

100

100

100

100

100

100

100

100

Coupon Rate

0.25%

0.25%

0.75%

0.75%

2.00%

2.00%

2.75%

2.75%

3.20%

3.20%

YTM

1.25%

2.25%

1.75%

2.75%

3.00%

4.00%

3.75%

4.75%

4.20%

5.20%

Notes: YTM = Yield to Maturity. YTM increases 1% and 2% from the coupon in these scenarios for each bond. The price of a Par bond is $1000. It is stated as 100.

Table-2 Summary of Changes to Bond Prices:

US TREASURY BOND

Maturity

2-yr

2-yr

5-yr

5-yr

10-yr

10-yr

20-yr

20-yr

30-yr

30-yr

Increase in Rates

1%

2%

1%

2%

1%

2%

1%

2%

1%

2%

% Chg Price

-1.97%

-3.89%

-4.77%

-9.28%

-8.58%

-16.35%

-13.98%

-25.64%

-16.97%

-30.22%

Note that Premium Bonds (bonds selling above 100) will decline more and discount bonds (bonds selling below 100) will decline less than above.

Table 2 is a summary of the changes in the price of the bonds for various maturities ranging from 2-years to 30-years. The longer the maturity, the greater the change in price. As you can see, the potential impact on bond portfolios absent any changes to holdings could be significant. I won't get into technical terms such as duration and convexity, as that is beyond the scope of this article. However, in its simplest terms, a 1% change in rates equates to a 1% opposite change in price for every year of a bond's duration. For a 100 basis point rise in rates (+1%), a 5-year bond will lose about 4.77% in value offset by a .75% coupon yield, for a total loss of 4%. Move out in maturity and the common 10-year UST would lose around 8.5% in value offset by only a 2% yield. When you look at a +2% change in rates, the numbers start looking pretty scary. My point is simply that the Fed faces a very tricky transition from its current policy of easy money to a return to normal. It's hard to imagine a scenario where interest rates do not rise as the economy strengthens and the Fed pulls back on easing.

So, what is an investor to do? First, rates are not expected to rise too much until the Fed signals that it will stop buying bonds. It could be into 2014 until rates move up materially. However, as the employment rate drops, investors will anticipate that the Fed will have to do something and will try to get in front of any Fed moves.

Start planning now. I'm not a bond expert by any means but a few things you should start doing now include the following:

  • Start talking to your investment advisor now about how your bond portfolio or funds are structured. Make sure your advisor is aware of the coming potential problem.
  • If you own individual bonds and intend to trade them rather than hold to maturity, consider buying shorter maturity (duration) bonds. The yield will be lower but the risk of a drop in the value will also be lower.
  • If you buy your own bonds (or your advisor does for you), consider a ladder of varying maturities. A typical 5-year ladder would have bonds maturing each year for 5 years. In this way if rates rise, you would reinvest the maturing bond at a higher yield.
  • Look at the duration of the bond funds that you own. In its simplest form duration is similar to maturity but also takes cash flows into consideration. Duration is stated in years. Each 1% increase in rates equates to a 1% decline in bond price for each year of duration. Longer duration portfolios will produce a higher yield but have much more price sensitivity to changes in interest rates. If you can't find duration, maturity will do. Morningstar's website lists duration and maturity of funds. I would suggest getting duration below 5 years for a good portion of your fixed income holdings. Diversify your holdings and stagger duration (maturity).
  • Short-term to intermediate term bonds will have the lowest interest rate risk but will also produce the smallest yields. Managers of actively managed bond funds should be able to maneuver the portfolio to provide some protection against changes in rates. Review the strategy of the funds you hold. Many ETF bond funds are passive and managers do not actively manage against interest rate risk.
  • Stay away from Zero-coupon bonds. Zero's have no coupon payments so they also have the highest duration based on their maturity.

These are just some of the things you should be doing now with your bond holdings. Don't get me wrong though, if there is a spike in rates it will not be good for stocks either. I'm sure the Fed's goal will be to let rates rise gradually; giving investors time to make changes to their portfolios. However, given the magnitude of bonds outstanding, this might be a steamroller that will be hard to stop once the selling starts.

DISCLAIMER: The material represents the views of Bob Centrella, CFA and the information is believed to come from reliable sources. Although we have reviewed the material we can't guarantee the accuracy and completeness of all the information. Do not rely on this information alone to make investment decisions. The information contained in this article is not intended to constitute financial advice, and is not a recommendation or solicitation to buy, sell or hold any security. This article is strictly informational and educational and is not to be construed as any kind of financial advice, investment advice or legal advice. We urge you to talk to a financial professional before making investment decisions for a discussion of risks involved.

Source: The Dirty Little Secret About Bonds - Is There A Coming Bond Armageddon?