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Blogs

The downside risk to bonds may be smaller than you think

Chuck Dale

June 27, 2022

Does the current market environment have you thinking twice about adding bonds to your portfolio?

In June, the Federal Reserve (Fed) raised interest rates by 75 basis points (0.75%), its largest hike in more than 20 years.1 The Fed has also said it plans to raise rates by another 50 basis points in its July meeting2, moving target rates from 0.0% - 0.25% to 1.75% - 2.0% since the start of the year.

The raises caused concern for bond holders, as even short-term bonds lost money due to increasing rates. While the concern is justified, it may be worth taking another look at bonds and calculating their true risk in a rising rate environment.
 

The relationship between interest rates and bond prices is inverse

When interest rates change, either up or down, bond prices typically change in the opposite direction due to their inverse relationship. Some investors may assume it’s a proportional relationship, meaning a 1% increase in interest rates results in a 1% decrease in a bond’s price. However, this is not the case. Instead, the change in price depends on the bond’s duration and convexity. Duration measures a bond’s price sensitivity to interest rate changes, while convexity measures how the duration changes with interest rates.

In general, the lower the duration, the less sensitive the bond price is to the change in interest rates. Therefore, in a rising interest rate environment, an investor could expect to “lose less” by owning a short-duration bond. Yet while principal return may be negative, one should also consider that the coupon of the bond will offset some (if not all) of the loss of principal.

For example, let’s look at the 5-year US Treasury. Based on the current coupon and duration, what impact would a 1% increase in interest rates have on its one-year return?


As you can see, a 5-year US Treasury would expect to lose 4.5% of its principal value. However, its current coupon of 2.9% would partially offset the loss of principal, resulting in a net loss of 1.6% for the year.
 

Reconsidering the safety of bonds in a rising rate environment

So far this year, rising interest rates have taken a toll on stock investors. Price-to-earnings ratios have compressed with the move in rates, leaving the S&P 500 down 14.86% through the end of May.3 While the bond investor in the example above lost money, that loss would have been less than that incurred by an equity investor. Additionally, the income provided by the bond coupon mitigated some of the downside of the loss of principal.

The key takeaway? Investors should not be scared of bonds in the current rising rate environment. Shorter-duration, high-quality bonds may offer better downside protection during an extended period of heightened volatility and uncertainty and may provide much better preservation of capital relative to equities.

 

Chuck Dale is a senior portfolio and relationship manager with CIBC Private Wealth, with more than 27 years of industry experience. He joined the firm in 1993 and serves as a trusted advisor for a select group of affluent individuals, families, foundations, endowments and pension plans.

 

1 CNBC. “Fed hikes its benchmark interest rate by 0.75 percentage point, the biggest increase since 1994.”
2 Bankrate.How much will the Fed raise interest rates in 2022? Here’s what experts are saying.”
3 Morningstar. “S&P 500 PR.”