Definitely. While there can be a number of causes, let’s discuss the one that’s on everyone’s mind lately: rising interest rates. Generally, as rates rise, bond values go down.
How much? That depends on a number of factors, including:
- How much did interest rates rise?
- How long until your bonds mature?
- Do your bonds have call features?
- How much do your bonds pay?
That’s a good list to know, but not too helpful in figuring out how much exposure you have to rising rates. Fortunately, there’s a statistic calculated for each bond that gives you a pretty good sense of your interest rate risk. It’s called “Duration.”
Duration tells you how much you should expect your bond to fall for each 1 percent rise in interest rates. So let’s say your bond has a duration of 10. If interest rates rise 2 percent, your bond should drop roughly 20 percent in value.
The years to maturity has the biggest impact on duration: the longer the maturity, the bigger the duration. In fact, if you wanted a quick ballpark estimate of your bond’s duration, take 2/3 of the years to maturity. For example, a bond that matures in 20 years might have a duration in the 13 to 14 area.
The second biggest factor is the coupon (i.e., the amount of interest your bond pays every year). The smaller the coupon, the higher the duration. Take, for example, the smallest coupon—a zero coupon bond that pays no annual interest. It’s like the old savings bond we had as kids—you buy it at a deep discount like $600, it pays nothing over its lifetime and then matures at $1,000. Zero coupon bonds have a duration equal to its years to maturity. That’s much higher than the typical coupon-paying bond at only 2/3 of the years to maturity.
When do you want to own higher duration bonds? Simple: When interest rates are falling, as they have for the past 30 years. During this period, higher duration bonds rose steadily in value.
But I believe interest rates have bottomed and will begin to rise. With very short-term interest rates (such as Fed Funds, or the rate you get on bank accounts) at virtually 0 percent and the 10-year Treasury hovering near 30-year lows, it appears that rates have nowhere to go but up. In such a rising rate environment, higher duration bonds will fare much worse than lower durations.
What is the duration of your bonds? You need to know. Ask your advisor—they’ll have it at their fingertips, for each bond and for your portfolio as a whole. If you own your bonds in a bond fund, you can pull up the fund’s duration from their website or financial sites like Morningstar.