First let’s talk about interest rates and your bond portfolio. As you may recall, over the summer Fed Chairman Ben Bernanke floated the idea that if the economics warranted it, the Fed would consider backing off some of the $85 billion per month that they pump into the economy through their bond buying program. Remember that artificial bond buying program–and there is no other name for it when you are buying your own debt– is designed to keep the prices of bonds high, which automatically keeps the interest rates low.
Low rates encourage people and companies to keep borrowing and also flushes banks with cash since they are the biggest sellers of those bonds to the federal government.
What happened when Bernanke merely hinted that someday they might start buying less than $85 billion per month of their own debt to keep rates artificially low? The market completely freaked and in a matter of months, the rate on a 10 year Treasury bond went from 1.63 percent to just under 3 percent.
Who cares? Anyone with any money in bonds needs to care because the 10 Year Treasury Rate drives most bond markets including corporate bonds and municipal bonds. When rates rise, prices automatically fall.
Here’s a hypothetical to think about: with that rise in the 10 Year Treasury Rate of over 1.3 percent in a very short period of time, a bond portfolio with a duration of let’s say 7 lost almost 10 percent of its value. Remember that duration is a mathematical measurement of how sensitive your bonds are to interest rate movement, whether you have individual bonds or mutual funds.
What does all of this have to do with the government shutdown and the window of opportunity that it might have created?
After Ben Bernanke scared the market with his comments, and convinced them that he would lower the stimulus plan at the next Fed meeting, it never happened. When the Fed met last month, the economic numbers did not justify slowing down the stimulus because the numbers weren’t strong enough. Since then the interest rate on a 10 year Treasury has dropped from almost 3 percent down to today’s rate of 2.6 percent, which have pushed bond prices back up a bit since the panic.
The question is, do you think our government shutdown increased the chances of the Fed slowing down the stimulus or increased the chances of them backing off?
The bond market seems convinced that it should be a while before we recover from the cost of the shutdown and that economic numbers will show more weakness than strength between now and February.
What does that mean for a bond investor? It means you have a limited window of time that rates might stay low and the shutdown was a gift, especially if your bond portfolio has a high sensitivity to interest rate movement. It is possible to lower the volatility of bond holdings without giving up yield. If you saw how the bond market reacted at the mere possibility of less stimulus, you may choose to use this opportunity to lower the duration of your bond holdings and decrease the interest rate sensitivity so when the inevitable happens, and rates rise, you will be protected.
Keep in mind that when you lower the duration of your bond holdings, you won’t be getting paid the same interest rate as someone who keeps their duration higher. Two things determine the interest rate that a bond pays in the open market:
- Duration, and
- Credit quality
For people who do not want to lower the interest rate that they are getting for their bonds but want to decrease the price sensitivity of the portfolio, they may adjust the credit quality of some of the bonds to make up for the lost yield of a lower duration portfolio.
In English, there is a way that you can lower you the volatility of your bond holdings without giving up yield.
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Information presented in this blog post is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Discussions and answers to questions do not involve the rendering of personalized investment advice, but are limited to the dissemination of general information and may not be suitable for all readers. A professional adviser should be consulted before implementing any of the strategies presented.