Rising Rates, Falling Prices: How to Protect Your Bond Portfolio?
Bond investments often fascinate people looking for a steady source of income. However, one must remember that the money you invest in bonds isn’t immune to market changes. Hence, bond prices are sensitive to interest rate changes! Amidst a dynamic situation, you need a strategy that helps you stay a step or two ahead of interest rate shifts. So, how do you do that? Let’s look at a few potentially effective bond management strategies to help you safeguard your bond portfolio.
Relationship Between Bond Prices and Interest Rates
Bond prices and interest rates share an inverse relationship. Thus, when interest rates increase, newly issued bonds offer higher yields. While that’s good for bond investors, it negatively affects the existing ones. It makes the existing lower-yielding bonds less attractive, thus reducing their prices.
While the above may not seem good news, it is a fundamental principle of bond investments. It leaves investors exposed to interest rate risk. It is a risk wherein their investment’s value will change due to fluctuations in the interest rates.
Hence, before you invest in a bond, you should understand the relationship.
Now, if you plan to hold the bond until maturity, interest rate risks may not bother you as much. They will be more confronting for people who look to sell the bond before maturity and may be compelled to sell at a discount to par value or below the initial purchase price of the bond.
Once a bond is issued, the investor can trade it in the secondary market, causing a fluctuation in the bond’s price, based on the supply and demand and interest rate changes. Additionally, the financial standing of the issuer would also matter.
As mentioned above, a rise in the interest rate makes a low-yield bond less attractive, resulting in a price drop below the initial par value in the secondary market. Current bond yields are determined by dividing the annual interest payment by the bond's existing price. So, a drop in the bond price makes its yield increase, helping it compete better against new bonds with higher rates.
Let’s look at a couple of situations of investors investing in bonds with the same par value but varying interest rates.
Situation 1: You buy a bond for Rs 10,000 with a 10-year maturity and a coupon rate of 2%. The par value would be Rs. 10,000. The investor will receive annual interest payments of Rs. 200. After 10 years, the investor will receive their Rs. 10,000 principal amount and Rs. 200 as interest.
Situation 2: Now, let’s say the interest rates rise and you buy a 10-year bond at Rs. 10,000 par value with a coupon rate of 4%. You will receive annual interest payments of Rs. 400. After 10 years, you will receive the principal amount of Rs. 10,000 after Rs. 400 as the interest.
In the above situations, the first bond became less valuable as it generated less income for you. Hence, its market value drops. If you decide to sell the first bond before maturity, you will likely have to sell it for a price less than Rs. 10,000. Thus, you will lose money on the principal and also won’t get the balance interest. So, in this case, the interest rate rise forced the bond’s market value to decline.
Interest rate changes are a macroeconomic phenomenon. Hence, no individual can control it. However, you can employ some bond management strategies to help fortify your portfolio from the impact of these changes. Let’s look at them.
Protecting Your Bond Portfolio – 4 Potential Bond Management Strategies
The four most widely followed bond management strategies include active bond, passive bond management, indexing, and immunisation. Let’s overview all four of them to develop an understanding to protect your bond portfolio.
Active Bond Strategy
Active management is exercised to maximise the total returns. However, opportunities are accompanied by risks. Some examples include timing valuation, interest rate anticipation, considering multiple interest rate scenarios and spread exploitation. Fundamentally, in this strategy, the investor makes bets for the future instead of settling for a potential low yield.
Passive Bond Strategy
Passive investors consider bonds a safe and predictable source of income. It involves buy and hold which includes purchasing individual bonds and holding them until their maturity. The cash flows these bonds generate become the investor’s income or are reinvested in other bonds or other investment avenues.
While working with a passive strategy, you don’t make assumptions about the direction of future interest rates. Besides, changes in the bond’s current value due the yield shifts also don’t matter. You buy the bond at a premium or discount assuming that will reach full par value upon maturity.
Here, the only change in the total return from the actual coupon yield is the coupon reinvestment that may happen.
The passive strategy works well with premium and non-callable bonds like the government ones. They help provide stable anchors during financially challenging times and minimize transaction costs. If you implement it during a period of comparatively high-interest rates, it may perform better than the active strategy.
Indexing Bond Strategy
Another significant bond strategy is the indexing bond strategy. It is similar to the passive strategy in its design. The primary aim of indexing a bond portfolio is to provide a return and risk feature closely tethered to the target index. Although similar to the buy-and-hold, indexing is a little flexible. You can structure a bond to replicate any published bond index. However, the strategy involves a couple of essential considerations like the transaction costs of the original investment and periodic portfolio rebalancing.
Immunisation Bond Strategy
This bond strategy looks to match the duration of assets and liabilities to protect the investment against interest rate changes. It refers to a portfolio invested for a defined return for a particular period, irrespective of any external influences or effects, including interest rate changes. The strategy can give you the positive potential of an active strategy for guaranteed returns on a portfolio. However, if you want to implement the buy-and-hold strategy in this one, you may want to do it with premium bonds less likely to default.
Some Other Strategies
In addition to the above, here are a few more strategies to help you mitigate your bond investment portfolio’s interest-rate risk.
Cut Short the Portfolio’s Duration
Amidst a rising-rate environment, if the risk goes beyond your tolerance, you should limit (not eliminate) duration. Reducing the duration can help you control volatility and confine your losses as the interest rates rise. However, do not exit the market, move to cash, or shorten your duration exposure significantly. With a cash strategy, you may soon find yourself retarding remunerative bonds and inflation as well. Although rising bond yields can hurt in the short term as prices drop, they can prove healthy across a broader timeframe.
Invest in High-Yield Bonds
Shortening the portfolio’s duration is one way but not the only one. Bonds with a yield spread above government debt, say, for example, corporate bonds are less sensitive to interest-rate levels. If you are an investor with a moderate risk tolerance, maintaining a balance of government bonds and interest-rate sensitive assets with growth-oriented credit assets in a single strategy can help.
Want to Invest in Bonds? Choose Altifi!
Bond investments are just like other investment avenues. They are sensitive to market changes and carry a certain amount of risk. Thus, these factors are deemed to be there. What matters is how well you handle the situation, manage your portfolio, and protect your returns to the best extent possible.
Consulting an expert to understand the technicalities of bond portfolio management can help you manage the situation better for your investments. However, if you’ve been looking to make new bond investments, choose Altifi, a bond investment platform. With listing of bonds and thousands of existing investors, Altifi can pave the way to bond investments. Sign up with us and add bonds to your investment portfolio.
Disclaimer: The contents of this article should not be construed as tax or financial advice. Readers should seek advice from their tax or financial advisor before making any investment decision.