Increasing Interest Rates & Bond Portfolio

The Key To Duration:  Portfolio Sensitivity To Changing Interest Rates

The market believes that the Fed will increase interest rates with ~99% probability based upon trading in the futures market.  With the Federal Reserve set to announce their targeted Federal Funds Rate on June 14th, we believe that this is a proper time to reevaluate the risks of fixed income as well as the metrics used to evaluate interest rate risk.

Bond prices move inversely to yields.  If yields increase, the price of a bond goes down and vice versa.  The price of a used car is analogous to bond prices in a rising rate environment. For example, an auto enthusiast is trying to sell a two year old car with 30,000 miles and squeaky brakes. A new car with the latest safety features, better performance, and zero miles can be purchased for $35,000. In order for our auto enthusiast to sell his used car, it would have to be priced less than $35,000. Much in the same way a bond that pays $40 a year would have to be priced lower to entice a buyer if new bonds pay $50 a year.  In the auto market, Manheim Market Reports can be utilized to estimate the depreciation of a vehicle. Fixed income enthusiasts utilize duration to gauge the price change of a bond due to a change in yields.

While we do believe that Janet Yellen will proclaim higher rates, we do not believe it is time to panic and take action driven by emotion.   Rather, the time prior to the eight scheduled meetings of the Fed is a good time to evaluate the risk exposure of a fixed income portfolio and reconcile this with required returns and tolerance for risk.