Interest Rate Risk in Bonds
Rapidly rising interest rates explain bond market losses in recent periods. The Bloomberg U.S. Aggregate Bond Index, a reasonable proxy for the U.S. bond markets, is off 4% over the past three months, confirming that bonds are risky.
Bond risk is from two sources primarily – credit risk and interest rate risk. Credit risk is straightforward – it’s the chance that the bond won’t pay interest and principal as agreed. The premiums for bearing this risk change primarily in response to changes in the economy. Interest rate risk is the variability in bond values in response to changes in interest rates. Recent results reflect the impact of changes in interest rates (interest rate risk).
Interest rate risk is not the same for all bonds. It depends on its duration (years to maturity adjusted by the effect of periodic cash flows). We can see the impact of duration on bond returns by looking at recent results for U.S. Treasury indices. Securities issued by the U.S. Government, by definition, bear only interest rate risk. The 1-3 Year Index earned 1%, while the 3-5 Year Index lost 1%, and the 7-10 Year Index lost 5% over the past three months. It’s only if the bond is to be held to maturity and there are no coupon payments (Treasury Bill or zero-coupon bond) that it will earn the yield implied when it was purchased. Otherwise, there is interest rate risk.
Bonds are risky – the sources of this risk are complex. It is important that they are well understood.
MARKET REVIEW
Stocks
While showing some signs of coming back, stocks are down this month, which brings the trailing three months’ numbers to negative 3% for the S&P 500 and 12% for the domestic small cap index (Russell 2000). In this three-month period our international market index (EAFE) and emerging market index (MSCI Emerging Markets) are down 6% and 8%, respectively. A globally diversified stock portfolio is off 8% over this period.
Clearly, there has been a reduction in the appetite for risk. However, while the turmoil in the Middle East gives us more to worry about, the economy seems in good shape – unemployment is low, inflation is falling, rapidly increasing interest rates are mostly behind us, and we seem to have avoided a recession. Of course, it’s hard to be optimistic about inflation when the average price of items that make up the Consumer Price Index (CPI) has gone up 30% over the past three years. The outlook seems better and, as the past few days have demonstrated, it can become positive quickly.
Bonds
Over the last three months, yields on short-term Treasuries have not moved from the 5.5% range. After moving up significantly, longer-term yields fell back in just the last few days of the month to where they are just above where they were at the beginning of the month. Over the trailing three months, on the other hand, these yields have pushed up – the current 10-year yield of 4.7% is up from 4%. Since bond prices move in the opposite direction from yields, we can see the impact of these increases in the 3.5% loss in the 7–10-year Treasury index. The spread between nominal and inflation-adjusted yields, a reasonable measure of the market’s expectation for inflation, has remained at a little more than 2%.
