Interest Rates Have Moved Higher: What That Means for Bond Investors

August 21st, 2012 by David Waring

(August 21st, 2012) Over the last 30 days we have seen the yield on the 10 Year treasury note move from below 1.40% to the current level of 1.81%. Here’s how that has affected bond investors.

Long Term Government Bonds

One of the most common bond funds that is followed by the fixed income community, is the TLT ETF. The TLT is designed to track the performance of the long term US Government bond market (US Government Bonds with 20 or more years until maturity). That means the bonds held by the fund have no credit risk, but lots of duration/interest rate risk. The duration of the TLT is around 17 years, which means that a 1% move in interest rates results in a 17% move in the price of the fund. (Learn more about bond duration.)

As you can see from the chart below the TLT has traded as high as $131.88 and as low as 121.01 based on close of day prices.

So in a worst case scenario where you bought at the highest point and sold at the lowest, you would have lost around 8.2% in the TLT. While this is a very large loss, as we will see below, it is actually not representative of what the average bond investor would have experienced.

Learn more about Government Bond Funds

Intermediate Government Bonds

Now let’s take a look at the IEF ETF, which tracks the intermediate term treasury market (treasuries with 7 to 10 years until maturity). The duration of this fund is around 7.3 years. As you can see from the chart below, the IEF has traded as high as 109.71 and as low as 106.59 over that same time period.

So in a worst case scenario where you bought at the highest point and sold at the lowest you would have lost around 2.8%.

What’s the Lesson we can learn from these two charts?

When investing in individual bonds or bond funds that hold bonds with a long time until maturity, small moves in interest rates can have a dramatic effect on prices.
While government bonds are free from credit risk, they are still exposed to interest rate risk. The move in the last 30 days has wiped out the interest paid on the IEF for the entire year, and several years worth of interest for those investors in the TLT.

Learn more about Bond ETFs

The Intermediate Term Corporate Bond Market

Next let’s take a look at the chart of the LQD which is the ETF that is very similar to the IEF in terms of duration (7.6 years). However, where the IEF includes only US Government bonds, the LQD includes only investment grade corporate bonds. As you can see from the chart below, the LQD has traded as high as $120.90 and as low as $118.30 over the last 30 days.

So in a worst case scenario where you bought at the highest point and sold at the lowest you would have lost around 2.2%.

What can we learn from this?

The fact that you would have lost around 2.8% in a worst case scenario investing in the IEF and 2.2% investing in the LQD would seem to indicate that the investment grade corporate bond market has tracked the government bond market pretty closely over the last 30 days.

If you look at the charts above for both instruments however, they tell a different story. Intermediate term government bonds, as represented by the IEF, have had a pretty steady march downward over the last 30 days. Intermediate term investment grade corporate bonds on the other hand, have seen most of their price decline in the last two weeks.

The reason why is that Interest rates on US Government bonds have been rising in large part due to investors increased optimism about the US economy and global. As investors become more optimistic they move money out of “safe haven” assets like treasury securities and put them to work in “risk” assets such as corporate bonds and stocks. So while interest rates in the investment grade corporate bond market have also risen, they have not risen as much as interest rates on comparable US Government bonds.

For those of you who have read our articles on credit spreads, this is another way of saying that the credit spread between corporate bonds and government bonds has narrowed.

Learn More about Credit Spreads

The Total US Investment Grade Bond Market

Next let’s take a look at the BND, which is an ETF which tracks the Total US investment grade bond market. This includes US Government bonds, Mortgage Backed Securities and Corporate bonds. It’s duration is around 5 years. As you can see from the chart below over the last 30 days the BND has been as high as $85.17 and as low as $84.09.

So in a worst case scenario where you bought at the highest point and sold at the lowest you would have lost around 1.3%.

What can we learn from this?

You can see the effects of the lower duration and diversification across the entire investment grade universe at play here.

Learn more about Bond Mutual Funds

The High Yield Corporate Bond Market

Next let’s take a look at the HYG, which is a Bond ETF which tracks the high yield bond market. Its duration is around 4 years. As you can see from the chart below the HYG ETF has actually risen in value over the last 30 days from a low of 89.95 to as high as 91.70.

What can we learn from this?

This is a perfect example of how in terms of price movements, high yield bonds have more in common with the equity market than they do with the bond market (you can learn more about why here) . The high yield bond market has benefited from the same forces which helped out investment grade corporate bonds, but to a much greater degree. Because high yield bonds have much more credit risk than investment grade bonds, their price will rise and fall much more dramatically when market optimism and risk perceptions change.

Learn more about Junk Bonds

The Investment Grade Municipal Bond Market

Lastly let’s take a look at a chart of the MUB which tracks the price movements in the investment grade, tax exempt municipal bond market. Its duration is around 6.3 years. As you can see from the chart below the highest the MUB has been in the last 30 days is 111.83 and the lowest its been is 110.87.

So in a worst case scenario where you bought at the highest point and sold at the lowest you would have lost around .85%.

What can we learn from this?

Investment grade municipal bonds tend to move in the same direction as US Government bonds, however with a bit less volatility.

The Bottom Line

Not all bonds are created equal, which is true even when looking at the same type of bonds with different maturities. When investing in bonds it is just as important to pay attention to interest rate risk as credit risk.

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