Markets are up. Your asset allocated portfolio is looking good. Nothing to worry about, right?
Wrong.
No one has a crystal ball, so this is not about trying to predict the future. This is about educating you on a number called effective duration, or in plain terms, the price sensitivity of your bond holdings resultant from a change in interest rates (yield). Considering we are in a period of rising rates, this is the number your advisor should be speaking with you about, but probably isn’t.
Let’s first discuss the basic concept of inverse correlation. Bond prices fall when interest rates go up. Why? Because in order to get me to buy your bond paying 3% when I could buy a new bond paying 4%, you need to offer me a lower purchase price to get my business. That is an oversimplification, but essentially the point nonetheless.
This brings us to effective duration, or the measure of a bond’s price sensitivity to changes in interest rates. With respect to interest rate changes short term bonds are less sensitive than intermediate term bonds, which are less sensitive than long term bonds. Take for example the Vanguard Short-Term Bond Index Fund ETF (BSV) with an effective duration of 2.78; meaning that a 1% change in interest rates impacts the price of this ETF by 2.78%. Applying what you’ve learned about inverse correlation, and considering we are in a rising rate environment, the impact to this ETF for a 1% INCREASE in interest rates will be a 2.78% DECREASE in the price of this investment. Comparing BSV to its intermediate term brother, BIV, the effective duration increases to 6.54. What is the impact to BIV on a 1% INCREASE in interest rates? You got it! The value of BIV will DECREASE by 6.54%.
Considering the Fed has already signaled an increase of 75 basis points for this year maybe it is time for you to review your fixed income investments and evaluate other options that still provide for a well allocated strategy, but with lower interest rate risk.
If you are interested in learning more about how you are currently invested and what the impact of rising rates is on your portfolio please reach out to us!
David M. Bonnichsen
B. Chemical Engineering, Georgia Institute of Technology
Our belief is that everyone deserves quality, affordable and disciplined advice regardless of their socioeconomic status. Our goal is to make a meaningful impact in your life every day and in return be the first call you make when advice and guidance is needed. Welcome to Phoenix, where you and your best interests are always first.