With low current yields and the growing prospect of future Fed interest rate increases, bond investors are certainly in a precarious position. Investing in long-dated bonds is generally a source of yield – but long-dated bonds could be significantly harmed with a rise in interest rates. Conversely, investing in short-dated securities with minimal interest rate sensitivity would likely continue to earn paltry yields.
Duration is a key measure of the sensitivity of the price of a bond to the change in interest rates. A bond with a long maturity will have a higher duration than a short duration bond with the same coupon rate and therefore a higher sensitivity to changes in interest rates. The benchmark 10-year US Treasury, which many bond investors likely have some exposure to, has a duration of almost 9 years. The Fed is expected to raise short term rates twice more this year, for a total of a 50 basis point increase in short-term rates. If the yield curve makes a parallel shift, the benchmark 10-year US Treasury will see a price decline of almost 4.5%. Investors on the longer end of the yield curve might have exposure to the 30-year US Treasury Bond, with a duration of almost 20. Assuming again that the same 50 basis point Fed interest rate rise in rates causes a parallel shift in yields, the 30-year US Treasury will see a price decline of almost 10%.
Investing on the short end of the US Treasury yield curve might make an investor relatively immune to interest rate increases, but comes at a cost of minimal yields. Some investors move down in credit quality to boost their yield. One popular way to do this is to invest in senior loans. Senior loans often fall below investment grade on the credit spectrum, but have minimal interest rate risk. The coupons paid by senior loans reset on a periodic basis – usually less than 60 days – leading to a minimal duration risk. However, the higher coupons paid by senior loans comes with higher risk of credit spread widening or even a default. In the event of a default or credit spread widening, significant losses could be seen on a loan.
Some investors choose to access the senior loan market by investing in closed-end funds that, in turn, invest in senior loans. Since closed-end funds can trade at a discount or premium to the actual net-asset-value (NAV) of the portfolio, blindly investing in closed-end funds can take on undue risk. Investor’s ravenous appetite for yield and senior-loan closed-end funds has driven many funds to trade near, or even at a premium to, the NAV of the fund. If credit spreads rise or defaults widen, investor sentiment in the sector could quickly change. As a result, discounts on closed-end funds could widen swiftly, causing additional losses on top of the likely NAV losses.
As demonstrated, navigating the bond market during periods of increasing interest rates requires patience, persistence, and a careful analysis of all of the risks associated with the investment. Pockets of value do indeed still exist – it’s just more difficult than ever to find them. Investors can mitigate risk and earn respectable returns with careful diligence and the help of a professional manager.