Bonds react to interest-rate developments. What it means for investors.
The price of a bond may change during the term. How interest-rate developments impact the value of fixed-interest securities, what role the duration plays in this, and how investors can strategically align their bond portfolios.
Bonds 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 by the debtor. If fixed-income investments are kept from their issue 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 bonds: If interest rates rise, bond prices fall and vice versa. In order to better understand these developments, it is worth taking a look at the duration.
Knowing the difference between duration and term
The term of a bond is the period between the issue and the redemption of the security.
The buyer of a bond usually receives annual interest payments during the term. The term is not influenced by rising or falling market interest rates.
Duration, on the other hand, is the average period of time it takes for an investor to recover the capital invested in a specific bond.
Interim interest payments are included. As a result, the duration is usually shorter than the term. The length of the duration therefore depends on the frequency of the interest payments and the amount of interest. The more frequent and the higher the payments, the shorter the duration.
The duration indicates how sensitive bonds are to interest-rate developments.
Furthermore, the duration indirectly indicates how strongly bonds react to market rate changes. The longer the capital commitment period, 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 the case of a specific interest-rate movement.
In order to reduce the possible risk of price losses, we recommend diversifying the securities across different terms. Even for a portfolio made up of several bonds, the interest sensitivity can be explained using the duration.
Four scenarios for the interest-rate structure of bonds
The interest structure reflects the returns of the same type of bonds across various residual terms. When shown on a graph, this is called the yield curve. Put simply, investors can see the yield a bond is expected to achieve depending on the residual term. 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 term is. The longer investors forgo their money, the more they will be compensated.
- Flat yield curve: In a flat structure, all residual terms have the same interest rate. This is usually the case when falling interest rates are expected.
- Inverse (falling) yield curve: Here, the interest decreases the longer the term is. When high interest rates are paid on short-term bonds, this tends to indicate an impending recession.
- 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 expectation of the direction in which the interest rate will change, the investor pursues a different strategy. The aim is to reduce losses in the event 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 focus is on coordinating the interest-rate risks of both sides (meaning assets and liabilities) with each other. The aim is to thus make the balance sheet immune to interest-rate movements.
Three basic strategies for bonds
- 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 bonds are combined with long-term bonds. In the middle, the investments have a medium duration. As a rule, this strategy is selected if the middle segment appears very unattractive.
Optimize bond yields – adapt strategy to interest-rate developments
Investors can optimize their return with the right strategy. At the same time, this 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 can provide a simplified forecast for this.