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When interest rates rise, bond investors worry. That’s because prices will fall.

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To prepare for that problem, investors can buy lower-duration bonds when it seems rates will start rising, says Patrick O’Toole, vice-president of global fixed income at CIBC Asset Management and co-manager of the Renaissance Canadian Bond Fund, an underlying fund in the Renaissance Optimal Income Portfolios.

“That means buying more shorter-term bonds,” he adds. “So you’d sell your 10-year bonds and buy bonds with maturities of, say, one to five years.”

Read: Clients should consider bond ETFs, say experts

Why would that help? O’Toole gives us the rundown.

What is duration?

“Duration gives you a rough estimate of the risk of a bond or a bond portfolio, [specifically] sensitivity to changes in interest rates,” says O’Toole.

Read: Now’s the time to overweight corporate bonds

Expressed in years, duration measures how much a bond or portfolio will rise (or fall) for every 1% annual decrease (or increase) in interest rates. It tends to be shorter than the term of the bond or of the bond portfolio. The longer the duration, the more the security’s price will change as a result of interest rate fluctuations.

O’Toole gives the example of a portfolio with a duration of six: “Let’s say a 1% rise in interest rates across the yield curve over a one-year period. That means you’d see about a 6% drop in the value of your portfolio.”

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To figure out your total return, he says, you add in the current yield—the yield you bought the portfolio at.

So, if:

  • Current yield = 2%
  • Duration = 6

And: Interest rates rise 1% over 12 months

Then:

  • Price falls 6%
  • Add: 2% current yield

Total return= -4%

Conversely, if:

  • Current yield = 2%
  • Duration = 6

And: Interest rates fall 1% over 12 months

Then:

  • Price rises 6%
  • Add: 2% current yield

Total return = 8%

But, why do prices fall when interest rates rise? Rates tend to rise “because the economy is stronger, and that’s leading investors to think that there’s a potential for inflation to move up,” says O’Toole. “Bond investors want more compensation [for that inflation], so they’ll demand higher yield.”

Read: Are high-yield bonds still junk?

How to play duration

By choosing bonds with lower duration, says O’Toole, “you’re less sensitive to an [interest-rate] rise—your portfolio wouldn’t fall in value as much as a longer duration portfolio would.”

To continue to capture return, “you’d then tend to wait for interest rates to rise. When you see a big enough rise in interest rates, you’d sell your shorter-term bonds. Yields are higher, so you go buy those new, higher-yielding, longer-term bonds.”

Corporate bonds also tend to be less sensitive to interest rates than government bonds. “They have higher coupons than government bonds because they’re riskier,” O’Toole says. “You may be buying big, stable companies, but they’re still not governments. They can’t tax you or print money to pay you back: they actually have to go out and earn money to make their coupon payments and to repay maturing bonds. So they’re riskier.”

As a result, investors demand more yield from corporate bonds. That makes them less sensitive to a slow rise in interest rates, especially if that rise is due to better economic conditions.

Read: Why companies issue high-yield bonds

“A stronger economy means their financial position is improving, which means the risk of them missing a coupon payment is actually declining. So what you tend to see when government bond yields are rising is that high-yield and investment-grade bonds tend to outperform Government of Canada bonds. So, you want more exposure to corporate bonds in a moderately rising rate environment.”

That’s exactly what O’Toole expects will happen.

“We forecast a moderate rise in interest rates, but nothing that requires major adjustments to clients’ portfolios.” That’s because while the economy is improving, secular trends like an aging population will keep inflation low.

“When we see bond yields get to the lower end of our [forecasted] range, we can reduce duration and protect value for clients’ portfolios,” he adds. “And when they get back to the higher end of the range, we’ll then increase duration in client portfolios.”

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In the meantime, says O’Toole, “We’re going to continue to hold more corporate than government bonds. That helps you keep the overall yield of the portfolio higher.”

Read:

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Originally published on Advisor.ca

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