Here's Why I Care Very Little About Interest-Rate Risk

by: The Financial Lexicon

As someone who has written hundreds of investing-related articles, two books on investing, and is the author of the monthly newsletter Income Investing Insider, I expect and welcome all sorts of feedback on my writings. After all, there are millions of investors, each with unique investment objectives and unique views on investing-related topics. Every once in a while, I will receive a question or comment that is worth answering in an expanded format so that as many investors as possible can read the response.

In recent days, a Seeking Alpha contributor who writes under the pseudonym Delta_Neutral posted comments in several of my articles. The comments all had essentially the same message (but stated in different ways): My bond-focused articles should include a discussion about duration and convexity and should effectively attempt to time the market so as to avoid mentioning bonds that later decline in price on an unrealized mark-to-market basis.

As readers who frequently read my writings are aware, when writing about individual bonds, I am focused on investors with long time horizons who plan to hold their bonds to maturity. On many occasions, I have stated in my bond-focused articles that I believe an investor's original intention should be to hold a bond to maturity. It doesn't mean someone will always do this, but I think that should be the original intention.

There was a time in my life when I was a full-time trader. During that time, I traded bonds (among other securities) and certainly had a laser-like focus on duration, convexity, and a whole host of other considerations. Given that Seeking Alpha is not a platform geared toward traders, that the market for retail-investors who trade individual bonds is virtually non-existent, and that my focus is no longer on trading individual bonds but rather on investing in individual bonds, I don't think repeated discussions of duration and convexity are a productive use of time. I certainly have mentioned duration in my writings, especially as it relates to bond funds (NYSEARCA:AGG). One example comes from a recent document I created called The Insider's Guide to Income Investing, which is a free PDF that introduces investors to the world of income investing and discusses the role various asset classes and asset-class categories might play in the income-focused investor's portfolio. In that document, I note the following about bond funds:

"Although I am not a huge fan of bond funds, I can think of two reasons why I might purchase one: First, if I want exposure to a particular part of the bond market but am uncomfortable buying individual bonds in or unable to adequately diversify in that part of the market. Second, if I can purchase a fund with a low/short duration at an attractive price (enough to provide what I consider a margin of safety)."

If you are going to invest in bond funds rather than in individual bonds that will, absent a default, mature at par, then I think duration is something that should be toward the top of your list of considerations. If, however, you are building a diversified portfolio of individual bonds that you intend to hold to maturity, then I think duration should be much lower on your list of considerations. Of course, that doesn't mean you should assume your bonds will never decline on a mark-to-market basis. As Delta_Neutral pointed out in his comments, I own a Cliffs Natural Resources (NYSE:CLF) long-dated bond that is trading far below the price at which I purchased it. In fact, there are several other bonds within my diversified individual bond allocation that are trading at prices that are lower than the price at which I purchased them. Some examples include CUSIPs issued by Alcoa (NYSE:AA), Newmont Mining (NYSE:NEM), Agrium (NYSE:AGU) and CF Industries (NYSE:CF). My bond allocation also includes several dozen bonds trading above the prices at which I purchased them. But here's the thing about the unrealized mark-to-market price declines that will drive people with more of a short-term focus crazy: I don't care about the price declines.

My individual corporate bond allocation includes the bonds of 79 companies and more than 79 CUSIPs, diversified across investment grade (NYSEARCA:LQD) and non-investment grade bonds (NYSEARCA:JNK). Within the diversified portfolio, I fully recognize the possibility that several of the issues will trade well below the price at which I purchased them at some point between now and maturity. Everyone who invests in individual bonds with the intent to hold those bonds to maturity should recognize that possibility. Among those 79 companies, there are even a handful that I think could (but you never know) trade at deeply depressed levels during the next recession. But when I purchased them, I decided the credit risk-to-yield was appropriate for my investment objectives and that the opportunity cost of waiting to find out if the bonds would one day trade far lower than at the time of purchase (i.e. trying to time the market) was not worth it to me.

In one particular article that was published last summer, Delta_Neutral recently commented that "All of these bonds have lost a lot of money recently because rates went up." Since the time of publication, benchmark Treasury rates have certainly risen. Interestingly, however, five of the seven bonds mentioned in that article are up (as of 9/30/2013) since the time the article was published. The reason that occurred despite rising benchmark Treasury (NYSEARCA:IEF) rates was the dramatic spread contraction in those bonds. Rather than spending my time writing too much about duration or convexity, I have spent a good deal of time writing about spreads, something I think is much more pertinent to individual bond investors with long-term focuses.

Finally, for those long-term individual bond investors who still get a bit queasy with unrealized mark-to-market declines in their bonds, ask yourself these four questions:

1. Has the issuer of any of your bonds defaulted on its debt obligations?

2. Is the issuer of any of your bonds in danger of defaulting on its debt obligations in the foreseeable future?

3. Will the bonds that are causing you uneasiness mature at par?

4. In the foreseeable future, do you anticipate being forced to sell any of your bonds in order to raise cash?

If you answer the questions (1) No, (2) No, (3) Yes, and (4) No, you should be able to rest easy. Take a long-term perspective on your holdings that are, absent a default, destined to mature at 100 cents on the dollar, and ignore the daily unrealized mark-to-market movements and the people who make significant efforts to try to scare you out of your bonds. Individual bond investors who plan to hold their bonds to maturity and who manage their liquidity properly can ignore the unrealized mark-to-market movements in their bonds and focus their efforts on finding the next investing opportunity, which hopefully will occur at higher yields.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long AA, CLF, NEM, AGU, and CF bonds. I am also long numerous other individual corporate and Treasury bonds.