For months now, the bond market has been difficult for income investors. Risks are high when rates are low, and the sudden move up in interest rates has pushed bond prices down. With rates having been so low for an extended period of time, investors are risking several years' worth of income if they hold bond funds as rates rise.
Bond prices fall when interest rates rise because older bonds making lower interest payments will need to remain competitive in the market.
For example, no one would buy a bond yielding 2% if a new one was issued paying 3%. In order to find buyers, sellers of the 2% bond would have to lower the price of the bond until it was low enough to offer buyers a 3% interest rate on the amount they pay for the bond. The exact amount of the price cut is determined largely by how much time is left until the bond matures.
The relationship between losses and interest rates might be easiest to see in iShares Barclays 20+ Yr Treas.Bond (ETF) (NYSEARCA:TLT)
because bonds with more than 20 years to maturity will show the largest reaction to interest rates.
iShares Barclays 20+ Yr Treas.Bond (ETF) (NYSEARCA:TLT) is expected to lose about 16.7% for each 1% rise in interest rates. This is determined by the duration of the bond or the bond fund. This value can be calculated, but most ETF sponsors provide the information on their websites. Bonds in iShares Barclays 20+ Yr Treas.Bond (ETF) (NYSEARCA:TLT)'s portfolio mature in an average of 27 years, so we can use the interest rate on 30-year bonds to test this theory.
The interest rate on the 30-year bond moved up by 1% between May 1 and Aug. 16. iShares Barclays 20+ Yr Treas.Bond (ETF) (NYSEARCA:TLT) declined 16.4% in price over that time. While the size of the price drop is not exactly equal to the duration, it is close and provides investors with an estimate of the damage their portfolio will suffer as rates rise.
To find an estimated duration for your portfolio, you will want to find the weighted average duration of your holdings.
For example, if you hold 50% of your fixed-income assets in iShares Barclays 20+ Yr Treas.Bond (ETF) (NYSEARCA:TLT), 30% in iShares Lehman 10-20 Yr Tresry Bond(ETF) (NYSEARCA:TLH)
and 20% in iShares Barclays 7-10 Year Trasry Bnd Fd (NYSEARCA:IEF)
, the math is shown in the table below.
Every fixed-income investor should complete this review to help quantify the risk they face. In this example, the investor would face a capital loss equivalent to 5.2 years' worth of income. In those terms, the risk of principal might not be worth the reward of interest payments to many investors.
To determine how many years of income are at risk, we must calculate the income from the portfolio. The next table shows the income based on a $10,000 portfolio allocated 50% to iShares Barclays 20+ Yr Treas.Bond (ETF) (NYSEARCA:TLT), 30% to iShares Lehman 10-20 Yr Tresry Bond(ETF) (NYSEARCA:TLH) and 20% to iShares Barclays 7-10 Year Trasry Bnd Fd (NYSEARCA:IEF).
Since the portfolio value is divided into these three funds, we can find the income by multiplying the yield by the weight. For TLT, for example, this gives us income of $146 ($10,000 portfolio with 50% in TLT, or $5,000, multiplied by 2.92%).