High Interest Rates Making Bonds Worthless?

Because of the uncertainty inherent in the stock market, the looming threats of inflation, rising interest rates, and geopolitical uncertainty, many conservative investors have a tendency to lean more toward fixed-income investments as opposed to stocks. However, investors need to realize that there is inherent risk in the bond market should interest rates suddenly begin to creep up as they have begun to do lately. This is more commonly referred to as "interest rate risk." The question then becomes: What is my exposure to rising interest rates, and how can I anticipate or measure the impact rising interest rates would have on my portfolio?

How Rates Affect Bonds

Bond prices are a function of several parameters: term to maturity, coupon interest rate, current yield in the marketplace, and credit quality of the note. Without going into too much of the mechanics, permit me to go through an illustration of the impact of rising interest rates and how they impact bond values.

Suppose ABC Healthcare Corporation issued 30-year notes 2 years ago, and the coupon interest rate on those notes was 6.25%. Suppose further that the notes are rated lower-end investment- grade quality (BBB+) by S&P, and the current yield on notes being issued today in a similar risk class has climbed from 6.25% to 6.75%. When you purchased these notes, the annual coupon interest you would be receiving was $62.50 paid semiannually. When you purchased these notes, you did so for their face value or par value of $1000. Now, because interest rates have climbed, these notes will have a value less than $1000. Keep in mind that, in lieu of default, you will still continue to receive $62.50 annually or $31.25 semiannually from now through the time the note matures.

However, because interest rates have risen in the marketplace, you can now purchase a similar note today for $1000 yielding 6.75% and receive more interest annually than the note you purchased 2 years ago. Therefore, the note you purchased 2 years ago will no longer sell for $1000 but at a discount to its face or par value, almost $63 less. In other words, you purchased an instrument for $1000 2 years ago, received interest totaling $125 over a 2-year period, and, if you decided to dispose of the note today, would receive about $937 for a note that has a par value of $1000 at maturity. Not a real fabulous return on your investment, especially when you have to consider that you will have paid income taxes on the interest received. And, of course, if interest rates dropped, the note would have increased in value.

The Term of Maturity Effect

Let us consider another instance. Suppose instead of having 28 years remaining until the note matures, there were only 5 years remaining until maturity. All other parameters are the same—the coupon interest rate is 6.25%, the current yield is 6.75%, and the credit quality is BBB+. In this instance the note would be worth not $937 but $979. What can be learned from this is the shorter the time remaining until maturity, the less volatile the note's price will be for a given change in interest rates, up or down.

Therefore, if considering a bond portfolio for a stable stream of income, try to shorten the duration and term to maturity of the bond to protect from the impact of rising interest rates. By purchasing individual bonds with varying maturities that are of investment-grade quality or better, you will minimize the chance of default by the issuing company.

If you are seeking to invest in individual bonds with less than $50,000, you are going to have a difficult time constructing a portfolio of bonds with varying maturity dates. The reason being is that in order to get competitive pricing on notes, you generally have to deal in lots of $25,000 (ie, 25 notes) or more. Hence, with $50,000 you will not get adequate diversification. Therefore, with small amounts to invest, mutual funds may prove the more viable option.

Diversification and Funds

So, if individual bonds are not an option, try a diversified bond or fixedincome fund. Using the Morningstar Principia database for the month ended May 31, 2007, I conducted the following search as a benchmark for comparison. I performed a filter of all fixedincome (bond) mutual funds that had met the following investment criteria:

• All funds had to be of at least average investment-grade quality (ie, BBB) or better;
• Only domestic US bond funds are under consideration;
• All funds in question had to have front- and back-end loads equal to zero;
• Municipals were not considered;
• All funds had to have at least a 10-year track record; and,
• The minimum initial purchase had to be no more than $50,000.

This sort yielded 721 funds that met these criteria.

The "average" fund had a 12- month yield of approximately 4.5% and an effective maturity of just over 61/2 years and duration of almost 4 years. The average 1-year, 3-year, 5- year, and 10-year annualized returns were 6%, 3.9%, 4.2%, and 5.3%, respectively. The average weighted coupon was 4.9%, and the average expense ratio was just shy of 1%.

Simply put, if the duration is 4 years, for a 1% change in interest rates, the average change in value of the fund is approximately 4%. Also an average coupon of 4.9% would mean that for every $1000 of par or face value, the average annual interest paid is $49. Again, keep in mind that taxes would have to be paid on interest income earned if the fund is not held in a tax-deferred account.

You can see that going the mutual fund route would incur additional annual expenses of 1%, which would erode returns. However, depending on your level of sophistication and the monies under consideration, mutual funds may be your only option for adequate diversification.

So, based on a portfolio duration of 4 years, if rates increase by 1% or 100 basis points, the value of the underlying portfolio would decline by about 4%. So, in a worst case scenario, if there was $1 million invested in such a portfolio, a 6% yield or $60,000 in income would be partially offset by a $40,000 decline in the value of the portfolio. In this case, the investor would still be ahead of the game by some $20,000 or by 2%. Additionally, if interest rates were to decline, there may be some capital appreciation realized on the portfolio, but chances are this would not occur in this economic environment.

Odds are that interest rates probably have a greater chance of increasing as opposed to decreasing. This does not occur overnight. Therefore it is important when selecting fixed-income investments to concentrate on the credit quality, duration, maturity, and yield of the investments within the portfolio.

Thomas R. Kosky and his partner, Harris L. Kerker, are principals of the Asset Planning, Group, Inc, in Miami, Florida. The company specializes in investment, retirement, and estate planning. Mr. Kosky also teaches corporate finance in the Saturday Executive and Health Care Executive MBA Programs at the University of Miami in Coral Gables, Florida. Mr. Kosky and Mr. Kerker welcome questions or comments at 800-953-5508, or e-mail Mr. Kosky directly at ProfessorKosky@aol.com.