I thought I would take a moment between barbeques to pen my quarterly letter. I’ll make this one brief, so we can all get back to some fun in the sun.
Anyone that has been following the financial press lately, has noticed that Ben Bernanke and the FOMC (Federal Open Market Committee) have gotten a little heat lately for their hinting that they may slow down Quantitative Easing. What I heard is: “There is the possibility, that sometime, maybe, if the economy continues to be hunky – dory, that we may think about slowing down our massive purchases of government bonds and mortgage backed securities…” Or something like that. What did most market participants hear?: “Run for the hills!” The reaction in the bond market was swift, the 10 yr Treasury yield rose from 2.2% on June 18th to 2.5% on June 21st.
Given the change, I thought it would be a good time to review the impacts on our current strategy for bond holdings in client portfolios.
What goes up must come down
(Or: Bond Math 101 – Duration Illustrated)
I think that the bond portion of a portfolio is frequently one of the least understood assets. Often, they are just considered the “safe” asset class and people leave it at that. But in a rising interest rate environment, that is not necessarily true, as we will discuss. For those of you that need a refresher, you should check out my previous letter: Bonds are the New Black. Go ahead re-read it, I’ll wait.
To illustrate the challenges, we’ll look at the performance of the prices of 4 bond ETFs around the time of the Fed announcement on June 19th (remember prices decrease when yields increase). Two are included the current client portfolios (SHY & CSJ) and two are not (IEF & LQD). Here are the ETFs and their respective durations (duration measures a bond or bond fund’s sensitivity to changes in interest rates, which you know if you re-read the previously mentioned article).
Treasury Bond ETFs:
SHY: iShares Barclays 1-3 Year Treasry Bnd Fd Duration: 1.8
IEF: iShares Barclays 7-10 Year Treasry Bnd Fd Duration: 7.6
Investment Grade Corporate Bond ETFs:
CSJ: iShares Barclays 1-3 Year Credit Bond Fd Duration: 1.8
LQD: iShares IBoxx $ Invest Grade Corp Bd Fd Duration: 7.6
The chart below illustrates how the funds reacted to the abrupt change in interest rates (data courtesy of Yahoo! Finance):
As you can see the shorter duration funds SHY & CSJ had a total decline of less that 1%. The longer duration products IEF and LQD had declines of up to 3.5% and 4.9% respectively. This is hardly the type of volatility that you expect from a “safe” asset!
In most cases, I recommend keeping the duration of your bond fund short in the current environment. I don’t expect the transition from ultra low interest rates to a more normal environment to be smooth, or easy. Rather, it will probably proceed with fits and starts – with the recent performance foreshadowing continued volatility. If you'd like to talk about how bond funds fit your situation, I'd be happy to talk with you. Also, if your friends or family have questions about bonds or any financial issue, please feel free to make an introduction or forward this letter. We provide Financial Planning and Investment Management services and would be happy to talk with your acquaintances. We will treat your friends and family with the same care and diligence that we treat you.
Brian McCann, CFP®
Note: The contents of this site are general in nature and not intended as specific investment advice. All investments are subject to risk; including loss of investment value. If you have any question regarding investments or concepts in these pages, please consult with an investment professional.