The Financial Industry Regulatory Authority (“FINRA”) has issued an Investor Alert to educate investors about the impact an increase in interest rates would have on bond investments. Interest rates influence the value of bond funds, as well as, the price of individual bonds.
Investors with bond investments should know the duration of the bonds in their portfolios. Duration indicates how much the price of a bond is likely to move with an increase or decrease in interest rates. The larger the duration, the more sensitive a bond will be to changes in interest rates.
With interest rates at near historic lows, interest rates are bound to starting going back up. When that happens, existing bonds, especially those with a low interest rate and a high duration, may experience a decline in price. Bond funds containing a majority of long-term bonds (with high duration numbers) will decline in price, possibly significantly, as interest rates increase.
If a bond is held to maturity, the holder can expect to receive par value when the principal is repaid, unless the bond issuer goes bankrupt or otherwise defaults. If a bond is sold prior to maturity, the sales price will be impacted by the prevailing interest rates and the bond’s duration.
FINRA provides an example of a 2 percent rise in interest rates on a medium investment grade corporate bond (rated BBB, Baa or similar). If the bond has a duration of 8.4 (10 year maturity, 3.5 percent coupon), it could lose 15 percent of its market value. The same bond with a duration of 14.5 (30 year maturity, 4.5 percent coupon) could lose 26 percent of its value.
The duration of a bond fund is usually identified in the bond holding statistics section of the fund’s Fact Sheet. Determining the duration of an individual bond will probably require asking your broker or the bond’s issuer.
A short duration does not mean a bond or bond-fund is risk free. Bond investments are still subject to inflation risk, default risk, call risk and other factors. A complete discussion on the risks of bond investing can be found at FINRA Smart Bond Investing by clicking here.