Bonds react to interest-rate developments. What it means for investors.
The price of a bond may change during the term. Learn how interest-rate development impacts the value of fixed-interest securities and how investors can strategically align their bond portfolio.
Fixed-interest securities react to interest-rate developments
Bonds are very simply structured investments: Upon acquisition, the investor knows how high the interest is and when the bond will be repaid. If fixed-interest securities are kept until the redemption date, the investor gets the full purchase price back.
During the term, the value of the bond can change due to various factors. For instance, if the general interest-rate level rises or falls. This is inversely proportional to the value of fixed income securities: If interest rates rise, bond prices fall and vice versa.
The duration model indicates how sensitive bonds are for interest-rate development
The average residual term of a bond is referred to as the duration. The longer the remaining duration, the more sensitive the bond is to interest changes. Therefore, the duration allows for a very precise – albeit simplified – forecast of the price development of a bond in case of a specific interest-rate movement.
In order to reduce interest-rate risks, we recommend diversifying the assets across different terms. Even for a portfolio made up of several fixed-interest securities, the interest sensitivity can be explained using the duration model. The predictive value of this model, however, greatly depends on the shape of the yield curve.
Four scenarios for the interest-rate structure of bonds
The interest structure reflects the returns of the same type of fixed-interest securities across various residual maturities. Government bonds are particularly relevant in this respect. A distinction is made between four types of interest-rate structures:
- Normal (rising) yield curve: For this interest structure, the interest is higher the longer the remaining term is.
- Flat yield curve: In a flat structure, all terms have the same interest rate.
- Inverse (falling) yield curve: Here, the interest decreases the longer the term is.
- Irregular yield curve: A combination of the aforementioned structures – for example, rising interest for short-term bonds and falling interest for long-term bonds.
Expected interest-rate development determines strategy for bonds
The interest structure can take different forms over time. Depending on the direction in which the interest rate will change, the investor follows another strategy. The aim is to reduce losses in case of an undesired interest-rate movement as well as maximize profits in case of an advantageous movement.
Among strategies, a fundamental distinction is made between those based on assets and those that also include the liabilities of pension funds or insurance companies. With the latter, the primary goal is to coordinate the interest-rate risks of both sides (meaning assets and liabilities) with each other. The goal is to thus make the balance sheet immune to interest-rate movements.
Three basic strategies for fixed-interest securities
- Even ladder: Equal distribution
With this strategy, investments are spread out evenly across all term segments. Periodically, short-term investments are sold in order to stock up on long-term investments and to recreate the original duration. This strategy is rather inflexible in terms of including a tactical expectation.
- Bullet: Concentration on one segment
The bullet strategy focuses on one term segment. This strategy is expected to perform better than, or at least not as poorly as, the rest of the curve. The duration of this strategy is very close to the selected term.
- Barbell: Every segment except one
Those relying on the barbell strategy avoid investing in a given term segment. Frequently, short-term investments are combined with long-term investments. In the middle, the investments have a medium duration. As a rule, this strategy is selected if the middle segment appears very unattractive.
Adjust the strategy to interest-rate development
Investors can optimize their return with the right strategy. At the same time, it protects against any losses due to rising interest rates. What the right strategy is, however, depends on the individual situation and the risk profile. Interest-rate expectations must also be taken into account. The duration model can provide a simplified forecast for this.