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Percentage rising (Sebastian Duda/Getty Images/iStockphoto)
Percentage rising (Sebastian Duda/Getty Images/iStockphoto)

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It's time to re-examine your bond strategy Add to ...

Ask me what will happen to the stock market if interest rates were to rise, and I’ll tell you I don’t have the foggiest clue.

Some traders will wake up and decide that the U.S. Federal Reserve feels the economy is getting better and profits down the road will increase. They might decide to buy. Some traders will decide that higher interest rates will make the cost of borrowing go up, squeeze corporate profits, and retard the recovery. They might decide to sell. How many show up at a particular moment determine whether stock prices rise or fall. In the process, the stock market might make reasonably large moves in either direction for the short term. Tomorrow both sides might both change positions. It’s noise trading and ought to be ignored.

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But, if interest rates rise, I can tell you with almost mathematical precision what will happen to your bond values. As interest rates rise, bond values fall until a person buying them today gets the current rate of return to maturity. That means the person selling gets a “haircut” or capital loss. For any given interest rate change, the most important variable to determine bond pricing is the time until the bond matures. The longer the time until the bond matures, the worse the damage.

As background, in 1981, former Federal Reserve Chairman Paul Volker drove interest rates to the low 20 per cent in order to cure inflation and a stagnating economy. Mission accomplished – the Fed has steadily lowered interest rates for over 30 years. Now, to recover from a near melt down of the world’s economy we have seen an unprecedented global effort by every important central bank to flood the world’s economy with liquidity and drive down interest rates to close to zero.

When interest rates fall, bond values go up, so there has been a lot of profit made by people speculating in bonds over the years as interest rates declined from high-teen rates of 30 years ago. Bond investors received their coupon rate plus capital gains. Thus, returns to those investors were considerably higher than had interest rates remained steady. However, zero is a natural lower limit for interest rates, so it’s very hard to imagine further upside. In real terms after inflation, interest rates are effectively at zero today. When interest rates rise, bond holders receive their coupon rates minus capital loss. And the capital loss is not trivial. It is easy to imagine a lot of painful downside for long-term bond holders.

Almost everyone agrees that the Fed will reverse course. Some day they will stop issuing dollars to buy bonds. They might even sell bonds and receive dollars back. This is the bond speculator’s worst nightmare. But, nobody knows when that might happen. It seems better to stay out of the way and keep your bonds short.

As it happens, our consistent philosophy is to preserve principal in our bond portfolio by holding only very short term bonds. These will display the least volatility as interest rates change. As their short term bonds mature, they will be replaced by bonds with current yields, so they quickly adjust to current market conditions. We think the appropriate position is to accept today’s rather meagre yields with low volatility rather than face a potential devastating loss of principal. We have not gotten many thank you notes for our bond performance by following this very conservative approach. But it’s a whole lot better than explaining to clients where all their money went when interest rates finally rise.

If you are holding a long-term bond portfolio, which I might arbitrarily define as a bond with more than three years until maturity, now might be a very good time to re-examine your strategy. Otherwise, some day soon it might get pretty ugly for your portfolio.

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