Interest rate risk – is it worth the bother?

Bonds as well as bond funds (also known as collective investment schemes or mutual funds) are classified and categorised to be at the lower end of the risk spectrum of asset classes within global capital markets. Their distinct defensive characteristics have shown time and time again that this asset class remains robust during times of heightened volatility as the consistent income feature makes the asset class appealing to investors. One of the key risks investors relate to with a bond investment is the credit risk (financial strength) of the bond issuer, however there are a number of inherent risks within a bond (or bond fund) which must not be overseen, and that is primarily interest rate risk.

The proper jargon for interest rate risk is duration risk and is defined as a measure of the sensitivity of a bond’s price movements (each bond has its own distinct features such as coupon, underlying yield and maturity date) to a given change in interest rate. In simpler terms, investors ought to know what price change to expect on a fixed income instrument with say for example an upward or downward shift in interest rates by 1.0%. The unit of measurement of duration is in years and is practically the time required for a bond to re-pay itself. If a bond has a duration of 4.5 years, this means that if interest rates had to go up (or down) by 1.0%, the price of that bond is expected to go down (or up) by about 4.5%, hence the inverse relationship between interest rates and prices.

The longer the maturity of the bond and the lower the coupon, the higher the duration and hence the greater the interest rate risk. In practice, for example, long-dated Investment Grade sovereign bonds bearing small coupons would have a larger inherent interest rate risk than say than a short dated High Yield bond with a higher coupon. Naturally, in terms of credit risk, these two types of bonds are miles apart and high yield bonds are riskier than investment grade bonds.

Particularly at times when interest rates are flirting with historical lows and bond spreads continue to grind tighter, the concept of capturing a bond or a bond portfolio’s credit risk becomes imperative, especially when the downside potential for yields to go lower is limited and the risk of interest rates to go higher is larger. Investors need to weigh the pros and cons of their bond investments (both directly through individual bonds and via bond funds) and need not needlessly expose themselves to excessive interest rate risk.

With interest rates being so low in today’s environment, albeit have seemingly began an upward trend, bond prices have shifted higher in the process. Just as much as bond prices go up, they can likewise come down, just like any other asset class, despite their defensive characteristics. In a rising interest rate scenario, investors would want to benefit from higher rates and the growth of the economy, thereby either shifting into equities or say by selling their bond holdings only to get back into the market a more attractive yields, and hence at subsequently cheaper bond prices. The concept is simple: the higher the bond duration (interest rate risk), the more volatile the price of the bond.

There are those investors who are simply interested in locking in a yield today and are not particularly concerned with bond price volatility (as long as the bond pays up in full at maturity), better known as buyers-to-hold. These investors are the type who are willing to extend their duration profiles (and hence expose themselves to greater interest rate risk) by going for longer dated bonds simply because they have no intention of selling their bonds throughout the lifetime of the bond. And this is where the concept of opportunity cost kicks-in in portfolio and duration management. It all boils down to interest rate expectations and likelihood of imminent changes in underlying interest rates.