Question: As a 68-year-old new retiree, I have about half of my portfolio in bond funds. But frankly, I'm questioning the wisdom of such a large fixed-income position given the prospect of higher interest rates. How can I tell how interest-rate-sensitive my portfolio really is?
Answer: Your question is a timely one. Investors, especially those in or nearing retirement, are rightly concerned about how the so-called safe portions of their portfolios are likely to behave in a sustained period of rising interest rates.
It's definitely smart to think about what risks might lurk in your portfolio, particularly in segments that you expect to be drawing upon for living expenses within the next several years. And it's also true that after a few decades' worth of declining interest rates, rates have much more room to go up than they do to go down further. That could spell trouble for bond prices if rates head up and continue to spike.
At the same time, I don't think it's a good idea to dump bonds altogether. As I noted in this article, current bond prices are already factoring in the possibility that rates could go higher in the future; it's not as though the threat of rising rates is a new concept that no bond-market participants have considered.
Moreover, shunning bonds carries risks of its own. With cash yields as low as they are currently, prematurely downplaying bonds in favor of cash carries an opportunity cost. And dividend-paying stocks, while perhaps a reasonable home for a portion of your portfolio that you might otherwise dedicate to bonds, have a much higher volatility profile than do bonds. A worst-case scenario for stocks will equal much higher losses than you're apt to see in an Armageddon-type scenario in the bond market.
It also helps to keep bond worries in perspective. Yes, rising rates tend to depress the prices of already-existing bonds on the market. But if you own individual bonds, you can simply hold them to maturity and reinvest the proceeds into bonds with higher yields attached to them. (Just make sure that you're adequately diversified and that you're not sinking too large a share of your portfolio into bonds with sketchy credit qualities, as discussed in this article.) And if you own a bond fund, you may see your principal value decline, but those losses will be at least partially offset by the fact that the manager can swap into higher-yielding bonds as he or she goes along.
At the same time, I completely agree that it's a good strategy to stress-test your bond holdings to see exactly how much interest-rate sensitivity is lurking there. One common rule of thumb is that for every 1-percentage-point increase in Treasury yields, an investor could expect to lose an amount equal to the fund's duration. But Vanguard fixed-income guru Ken Volpert shared a refinement to that rule of thumb at the Bogleheads in the fall of 2010: To estimate how much an investor could lose during a 12-month period if Treasury yields increased by 1 percentage point during that same 12 months, subtract a fund's SEC yield from its current duration. That rule of thumb accounts for the fact that even though the uptick in rates leads to principal losses, the investor recoups part of that loss in the form of income during the 12-month period.
To use a current (and widely held) example, Vanguard Total Bond Market Index (VBMFX) currently has an SEC yield of 1.47% and an average duration of 5.0 years. That means if yields increased by 1 percentage point during a one-year period, one could expect the fund to lose roughly 3.5% during that same time frame--the 5% expected loss of principal would be slightly mitigated by the fund's 1.47% yield. If yields increased by 0.25% during a one-year period, the fund would stand to earn a slightly positive return during that stretch. (A 5.0-year duration multiplied by the interest-rate increase of 0.25 equals a 1.25% loss of principal over the one-year period, but the investor also earns a 1.47% yield during that time, so the fund's one-year total return would be approximately 0.22%.)
Meanwhile, the projected losses for long-term U.S. Treasury bonds amid a period of rising rates look a lot more alarming. Vanguard Long-Term Treasury (VUSTX), for example, has posted a scorching 10-year annualized gain of 7.5% during the past decade. But given the fund's duration of 15.5 years and yield of 2.54%, shareholders could expect to lose roughly 13% of their principal during a one-year period if Treasury rates were to jump up by 1 percentage point during that same time frame. That example illustrates that if you're concerned about rising rates, avoiding long-term bond funds is a good starting point.
And while duration is a handy measure, there are some limitations of which you should be aware. Investors use changes in Treasury yields as a proxy for what's happening with interest rates, and changes in Treasury yields are a good predictor of what you can expect from a Treasury fund's performance. But other types of bonds won't be as responsive to changes in Treasury yields, as Eric Jacobson details in this article. Thus, it's a mistake to derive a false sense of precision from the aforementioned rule of thumb, particularly if you're dealing with a bond type where there's a substantial differential between its yield and that of Treasury bonds.
A version of this article appeared Nov. 15, 2011.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.