The Financial Industry Regulatory Authority issued an Investor Alert regarding bonds, duration and interest rates. FINRA is specifically warning investors of the perils of an interest rate increase and its relationship with bond fund durations.
Investor Alert: Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio
Duration is a number that corresponds not just to a period of time, but also to how sensitive a bond investment is to a change in interest rates. The more sensitive a bond, the more pronounced fluctuations in price will be during an interest rate increase or decrease.
A lower duration signals less sensitivity while a higher duration number indicates greater sensitivity.
All else equal, a decrease in interest rates will produce an increase in bond fund value while an increase in interest rates will decrease this value.
Duration assumes that for every interest rate action, there is an equal yet opposite reaction in value and does not consider potential mitigating responses, such as a homeowner's attempt to refinance when rates drop. "Convexity" is the term used to account for this type of a response.
However, with interest rates presently stagnant near all-time lows, economists predict that rates will likely eventually rise, rather than fall, meaning that bond portfolios with greater duration (and therefore greater sensitivity) may be susceptible to significant price drops in the future.
For instance, FINRA calculates that a sample medium investment grade corporate bond (e.g., BBB) with a duration of 8.4—indicating a 10-year maturity and 3.5 percent coupon—could lose 15 percent of its market value if interest rates were to rise by two percent.
To illustrate the greater duration risk associated with a higher duration, FINRA applied the two percent interest rate increase to a similar investment grade bond, only this bond's duration was 14.5—indicating a 30-year maturity and 4.5 percent coupon. All else equal, this 14.5-duration bond could expect to lose 26 percent of its value.
Bond funds respond similarly.
For instance, a one percent rise in interest rates may correlate with a 10 percent decrease in value for a bond fund with 10-year duration. A bond with shorter duration, meanwhile, will experience a lesser decline in value—for instance, a two-year duration fund will decrease in value by two percent, given a one percent rise in interest rate.
Bond fund durations may be found in the fund's Fact Sheet, generally under the heading "Bond Holding Statistics." Note that some portfolios calculate more than one duration number, such as the case of a Macaulay Duration vs. Modified Duration vs. Effective Duration.
The Securities Industry and Financial Markets Association (SIFMA) also offers a free online General Bond Calculator which may be used to calculate duration and yield for different bond transaction scenarios.
FINRA VP of Investor Education Gerri Walsh explains that this alert's purpose is to ensure investors know their duration numbers and to ensure they "understand that outstanding bonds with a low interest rate and high duration may experience significant price drops if interest rates rise."
If you believe you have been misled or coerced into acquiring a bond or bond fund with a high duration without being advised of the added risk associated with long-term durations and this has proved harmful to your investments or interests, please call The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for an investigation and consultation.