Chris Forrest- Senior Partner and Principal Adviser
Sovereign Wealth Partners
- The relationship between the yield and price of a bond is inverse
- For every 1% change in interest rates, the price of a bond will change by 1% for each year to maturity
- Interest rates have increased over the last year making bonds more attractive then they have been over recent years.
We all know interest rates have been raised by Central Banks globally over the past six months or so. They have done so aggressively and are expected to continue to do so for the balance of the year.
As a result of this, yields on bonds have risen to reflect actual and anticipated increases, making them a more attractive investment than they have been over recent years.
But bonds have also fallen in value over the last year which raises the question, how do we measure the risk of a bond? One characteristic used is duration.
Bond duration is a way of measuring how much a bond price is likely to change if interest rates move. Put another way, it is a measurement of interest rate risk.
Before understanding duration, it’s important to understand the relationship between interest rates and the price of a bond. The important concept is that the relationship is an inverse one i.e. if interest rates go up, the price of bonds comes down and vice versa. Think of it this way, if you bought a 3-year bond today paying 3% per annum and tomorrow interest rates increased to 4%, your bond would be unattractive unless sold at a lower price than you paid.
As a general rule, every 1% increase or decrease in interest rates means there will be a corresponding change in the price of a bond by 1% for every year of duration.
(If you own a bond, this only matters if you want to sell the bond. If you hold it to maturity you can still expect to receive your coupons (interest payments) and face value of the bond (principal) at maturity).
So, is duration your friend or foe? It depends…….
Over the last year it has certainly been your foe. Interest rates have risen drastically from emergency levels over the course of the year. Little wonder the Bloomberg AusBond Composite index recorded
-9.81% for the year to 31st July 2022.
Similarly, the global equivalent (hedged to Australian dollars) recorded -8.23% for the same period. Both returns were worse than equities! Not so defensive after all.
However, there is the other side of the interest rate cycle. At some point, interest rates will peak, economic activity will slow, and interest rates will be cut. At the peak of the interest rate cycle, bonds have a role in generating income. At this part of the cycle it can be expected they will once again have defensive attributes not seen this past year.
Looking at the other side of the interest rate cycle, as economic conditions deteriorate, rates will inevitably be cut and bonds might be expected to appreciate in value. At this point of the cycle bond duration will more likely be friend rather than foe.
Whilst bonds can be bought directly, most investors gain exposure via managed funds (listed and unlisted). The duration of a managed fund portfolio is typically expressed by the manager as a single figure, giving the investor an insight into the overarching view a fund manager may have about the current level of interest rates.
For more information, contact your adviser at Sovereign Wealth Partners.