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The Impact of Rising Interest Rates on Your Fixed-Income Fund

It has been a while since interest rates went up in the U.S. and Canada. Given Canada’s struggle with economic growth, it is unlikely that interest rates will rise in the next two quarters. However, they won’t and can’t stay low forever. If inflation starts to test the outer 3% range that the Bank of Canada likes to maintain, interest rates will likely start going up. It is a slightly different story in the U.S. and UK. They have chosen not to go crazy over balancing their budget (or debating what a recession means).There is growing consensus that interest rates will gradually start making a move upwards in those countries. The recent stock market correction, however, has made things a bit unclear regarding the timing of the event.
Canada vs. U.S. Interest Rate

Why Should You Care About Interest Rate Changes?

If you are an investor in fixed-income instruments, interest rates might have a direct impact on your income. You should sit up and start taking notice if you are heavily invested in them. Don’t let a “finance” guy dressed up in a bespoke suit tell you to relax and not to worry. Nothing in this world comes without its share of risk. Whether it will impact you adversely or not will depend on what kind of fixed-income securities you hold and what you intend to do with them.

Let’s dig into the steak.

If you hold normal government or municipal bonds with a fixed maturity and yield, you should be okay (municipal bonds default on very rare occasions). In this case, you are likely to get your interest on time and principal back when the bond matures. However, the story changes if you bought riskier bonds from corporations (especially if interest rate hikes start to affect their bottom lines). Also, if you don’t intend to hold the bonds all the way to their maturity (i.e. you intend to sell them), then you are exposed to principal risk. If it sounds strange, you are not alone to think so.

If you hold bond funds, the story becomes even more complicated. Technically speaking, bonds and bond funds are separate asset classes all together. On the one hand, you hold the bonds and the contract is between you and the borrower. On the other hand, you and other investors pool in money and give it to an expert to manage. The expert then goes shopping on your behalf and buys you shares in a diversified portfolio of bonds with varied interest rates and maturities.

The Math Behind the Risk

Coming back to the main point: why do interest rates affect fixed-income investors at all? And how does the risk change if you decide to sell those securities or hold them for a long time?

Let’s say you bought a $1,000 bond at par (paying its full face value, to keep things simple) at a 3% coupon (giving you an income of $30 per year). And while you hold the bond, the interest rate rises to 4%. Newly issued bonds with similar ratings will now start giving a coupon of 4%. Investors are therefore less likely to buy your bond for the same price because they are getting a higher coupon elsewhere. So your $1,000 bond will be worth less should you decide to sell it.

How much less? Let’s do some rough math.

The new buyer will expect a 4% interest rate as per the going market rate. Now, since your bond will only pay a $30 coupon, the loss is covered up by buying the $1,000 bond for $750 ($30 interest on a $750 principal gives the buyer a 4% return). If, however, you hold the bond till maturity, you will get the full $1,000 face value back, barring any defaults. Another approximate method to ascertain the interest rate impact on the value of your bonds is to multiply the duration by the interest rate increase. So if your $1,000 bond had a duration of 20 years, a 1% increase by the Central Bank would chop down the value by approximately 20%. If the rate increase is 2%, it will reduce the value by 40% and so on.

Let’s take the same scenario for a mutual fund holding bonds. When interest rates rise, the market value of bonds decreases (as described above) and that means the net asset value (NAV) of the fund decreases. So the units you bought will be worth less. There is no concept of “holding to maturity” in this case because the fund manager will keep changing their portfolio of bonds, and that will keep changing the duration/yields. In addition, the NAV is a changing number and it could recover in the future (just like stocks). Any losses or gains you have in the short term might change in the long run.

The Bottom Line

In real life bond value calculations are not as squeaky clean as in the examples above. The examples were just to understand the logic behind the drop/rise in bond values when rates increase. The market doesn’t wait till the last moment to decide on a price correction. Things like interest rate changes are anticipated and the current price of bonds (which are continuously being traded in the secondary market) always accounts for what is expected in the short/medium term. In the case of bond funds, there is an additional complexity of investors selling their shares to cut their losses (when they see the prices drop). This puts pressure on fund managers, who might end up selling their high-yield bonds to make the payments which further impacts the NAV. On top of that, there might be a shift in credit ratings for bond issuers which would impact the prices of instruments connected to them.

It is important to remember that a 15-20 year period is a long time and that losses/gains are only notional unless you try to sell or close your investment (also known as “realizing” your gains/losses). To protect yourself, diversification is the name of the game. That advice has never changed, irrespective of what your investment objectives are. If you hold a good mix of individual bonds (some with short-term maturities or floating-rate bonds) and carefully invest in a mix of bond funds that match your risk appetite, you are better placed to sail through the interest rate head winds.

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Sep 25, 2015