Extension risk is often unanticipated, but can adversely affect fixed income investors during periods of rising interest rates
When interest rates fall, it's not uncommon for investors to see their callable bonds redeemed before maturity. For issuers, calling bonds is a chance to refinance debt at lower rates. For investors, a bond call is the source of considerable angst, but one for which they are typically compensated through higher yields - at least until the bond call itself.
But call features can have unpleasant consequences when rates rise as well. Lurking just below the surface is something known as extension risk. Extension risk is a little-appreciated aspect of how callable securities can behave in a rising rate environment. Too often, extension risk will sneak up on unsuspecting investors, leaving them wondering what happened. Extension risk can be prevalent in securities with imbedded call features and fixed coupons, which is often the case in mortgage-backed, municipal, and fixed preferred securities. In my view, too many investors think of their preferred "stocks" as equity-like, ignoring the very bond-like risks that these hybrid securities typically carry in a rising rate environment.
Declining interest rates increase call risk …
Extension risk stems from the fact that a callable security's sensitivity to interest rate movements (typically measured by duration) is not static. It changes according to the likelihood of that security being called away. Generally, a callable security is less sensitive to interest rate movements when rates are low, because that bond is more likely to be called. Conversely, a callable security is less likely to be called as interest rates rise, and its price becomes more dependent on interest rate levels.
An issuer views a callable security much like you would your mortgage. If interest rates are low, you would take advantage of the opportunity to refinance. That's what the call feature allows the bond issuer to do - call away the higher coupon bond outstanding and replace it with a cheaper form of capital.
Because the market expects the issuer to take advantage of the call feature when interest rates are low, the bonds are treated as if they will be around only until their call date. Thus, a callable bond's sensitivity to interest rate changes will be little different from that of a non-callable bond - known as a bullet bond - that matures on or near that call date.
… But rising interest rates increase extension risk
But what happens when rates start to rise? Initially, the callable bond behaves very much like a non-callable bullet bond. With market rates still below the callable bond's coupon, the likelihood of the bond being called is high, and interest rate sensitivity (duration) is low.
As market rates approach the callable bond's coupon, however, the likelihood of the issuer calling the bond decreases. At the same time, the callable bond's expected life "extends," and markets start to treat the bond like a longer maturing instrument with greater interest rate risk. The risk of the bond's effective maturity lengthening is known as extension risk. This phenomenon is illustrated in the chart below, with a few caveats below it.
Extension risk in action
This chart is purely for illustrative purposes. The anticipated change in price is purely a theoretical calculation based on the change in interest rates multiplied by duration. Duration is not linear. As rates move, duration changes uniquely for each security. Credit spreads aren't static, and widening or tightening can affect total return. Supply and demand may also skew price returns.
Unsuspecting investors may be tracking a security with relatively low interest rate risk, only to wake up one day facing a much more volatile instrument with high rate sensitivity.
Strategies for dealing with extension risk
Fortunately, there are strategies that investors can utilize to help address extension risk:
- Awareness - Familiarize yourself with the extension risk in your portfolio. The most obvious indicator can be a gap between a security's call date and its maturity date. A gap of two or three years may not translate into meaningful extension, but gaps of 10 years or more may mean higher volatility as rates rise.
- Bullets over calls - If you're concerned about extension risk, consider looking to more bulleted type securities, which can't be called, or securities with smaller gaps between call dates and maturity dates.
- Variable rates - Debt securities with floating or variable rates may help protect investors from a rising rate environment. Even if maturities extend beyond a call date, interest rate risk can be much lower and is limited to the time until the next rate reset.
Regardless of the path you choose, it's essential to understand how extension risk can affect a fixed-income allocation - particularly in a volatile rate environment.
Investors concerned about extension risk may wish to consider the PowerShares VRDO Tax-Free Weekly Portfolio (NYSE:PVI), the PowerShares Senior Loan Portfolio (NYSE:BKLN), or the PowerShares Variable Rate Preferred Portfolio (NYSE:VRP) - all of which feature variable rate structures.
Duration, which measures the price sensitivity of a fixed income investment to interest rate changes, is the number of years it will take a bond's cash flow to repay an investor the bond's purchase price.
Floating rates are interest rates that are allowed to move up and down with the rest of the market or with an index.
A credit spread is the difference in yield between bonds of similar maturity, but different credit quality.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating. Junk bonds involve a greater risk of default or price changes due to changes in the issuer's credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer's ability to make payments of principal and/ or interest. Income may be subject to state and local taxes and to the alternative minimum tax (AMT).
If interest rates fall, it is possible that issuers of callable securities will call or prepay their securities before maturity, causing the Fund to reinvest proceeds in securities bearing lower interest rates and reducing the Fund's income and distributions.
Variable- and floating-rate securities may be subject to liquidity risk, there may be limitations on the Fund's ability to sell securities. Due to the features of these securities, there can be no guarantee they will pay a certain level of a dividend and such securities will pay lower levels of income in falling interest rate environment.
Underlying investments may appreciate or decrease significantly in value over short periods of time and cause share values to experience significant volatility over short periods of time.
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund's return may not match the return of the Underlying Index.
Investments focused in a particular industry are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
The Funds are subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Fund.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article was posted on the Invesco PowerShares' blog by an Invesco PowerShares' employee on August 18, 2015: http://www.blog.invesco.us.com/extension-risk-when-interest-rates-rise-fixed-income-investing