By Richard Livingston 23 Mar 2016

A primer on interest rate risk

We explain the concept of interest rate risk and how to assess how much risk you’re taking on your term deposit and bond investments.

Snapshot

  • Term deposits don’t change in price but still have interest rate risk
  • Bonds change in price as market interest rates move
  • Rules of thumb for estimating the price risk on bonds

In Investing in safe assets, we explained why some investors should allocate a reasonable portion of their portfolios to ‘safe assets’ such as term deposits, bonds and funds that invest in these types of assets. While we’ve coined the term ‘safe assets’ to describe them, these types of assets are not without risk, a key one being ‘interest rate riskThe risk that arises to holders of bonds and other debt securities from fluctuating interest rates. The value of a fixed rate debt security will fall as interest rates rise (and vice versa). The amount of interest rate risk depends on the term or duration of the bond/portfolio of bonds.’.

Any time you invest in an interest rate security you’re making a bet on the future direction of rates. Interest rate riskThe risk that arises to holders of bonds and other debt securities from fluctuating interest rates. The value of a fixed rate debt security will fall as interest rates rise (and vice versa). The amount of interest rate risk depends on the term or duration of the bond/portfolio of bonds. is the risk of getting that bet wrong. For example, buying a five-year fixed rate security today is a bet that floating rates (on securities with similar credit riskThe risk of loss of principal (or accrued interest) on a loan or other debt security. Generally, the higher the credit risk associated with a loan or security, the higher the interest rate payable.) will produce a lower return in total over the next five years.

Term deposits aren’t traded like bonds, so movements in interest rates aren’t reflected in the price – you just miss out on higher rates. Bonds are priced regularly, so interest rate movements are instantly reflected in the price – making them harder to ignore. Either way, small movements in rates won’t have much impact on your returns, but big moves will. This is the risk you need to worry about.

Let’s take a look at how changes in interest rates can affect term deposit investors.

Term deposit example

Imagine you’ve got $100,000 to invest. Because of the low rates on one to four year term deposits (most are less than 3 per cent) you decide to invest it in a five year term deposit with RaboDirect paying 3.5 per cent a year.

A year from now, there’s a rapid increase in interest rates and a four year RaboDirect term deposit pays 5.5 per cent. If you had the money available you could invest at this higher rate, but you don’t. It’s locked up in the five year term deposit.

The decision to invest in a five year term deposit means you’ll miss out on earning 2 per cent a year for the next four years (at current interest rates). While term deposits can’t be traded (and so don’t have a price that moves) economically you’re out of pocket $2,000 a year, or $8,000 in total over four years.

If you could sell your term deposit today you’d have to do so for around $8,000 less than the original investment to compensate the buyer for the income forgone. In other words, your term deposit is worth around $92,000 (although in practice you’d need to make a slight adjustment for time value of money). However, unlike a bond, you don’t see this fall in value, you simply miss out on extra interest every year until the term deposit matures.

One way to avoid this interest rate riskThe risk that arises to holders of bonds and other debt securities from fluctuating interest rates. The value of a fixed rate debt security will fall as interest rates rise (and vice versa). The amount of interest rate risk depends on the term or duration of the bond/portfolio of bonds. is to invest the $100,000 in a shorter term deposit (say, six months) instead. However this approach simply means you’re swapping ‘interest rate riskThe risk that arises to holders of bonds and other debt securities from fluctuating interest rates. The value of a fixed rate debt security will fall as interest rates rise (and vice versa). The amount of interest rate risk depends on the term or duration of the bond/portfolio of bonds.’ for ‘reinvestment riskThe risk that cashflows from an investment will not be able to reinvested at the same rate as they were originally invested. The shorter the term of the investment and/or the greater the amount of periodic cashflows (especially in early years of the investment) the greater the amount of reinvestment risk.’. While you’d win out if interest rates rise, you’ll lose out if interest rates fall. If interest rates fall to, say, 2.5 per cent, your annual income would fall from $3,500 to $2,500 – almost a 30 per cent drop in income.

You would also miss out on the ‘term premiumThe difference between a long-term interest rate on a bond (or deposit) for a particular period and the market's expectation of cumulative short-term interest rates over that same period. It is a function of investors charging for the illiquidity of a longer-term investment. For example, if the market expects six month rates to remain at 3 per cent for the next two years, two year rates might be slightly higher than 3 per cent, reflecting the 'term premium' on a two year investment.’ you earn when you lock your money up for a longer period of time. Fixed term rates are typically higher than the sum of the expected short term rates over that period, with the difference being the ‘term premiumThe difference between a long-term interest rate on a bond (or deposit) for a particular period and the market's expectation of cumulative short-term interest rates over that same period. It is a function of investors charging for the illiquidity of a longer-term investment. For example, if the market expects six month rates to remain at 3 per cent for the next two years, two year rates might be slightly higher than 3 per cent, reflecting the 'term premium' on a two year investment.’.

The key point here is that investing in either long-term or short-term deposits or bonds is a bet on the future direction of interest rates. Fixing for the long-term exposes you to rising interest rates and sticking with short-term fixed, or variable rates, means you’re betting against rates falling.

While we’re conscious of the risk of rising interest rates, that doesn’t mean we recommend holding everything in short term deposits. The risk of a substantial fall in income is likely to be just as problematic for most investors (or more problematic) as missing out on some of the upside from higher interest rates.

That’s the basic principles of interest rate riskThe risk that arises to holders of bonds and other debt securities from fluctuating interest rates. The value of a fixed rate debt security will fall as interest rates rise (and vice versa). The amount of interest rate risk depends on the term or duration of the bond/portfolio of bonds. when it comes to term deposits. Let’s look now at how it impacts bonds and the funds that invest in them.

Bonds, bond fundsFunds (unit trusts) which invest in a portfolio of underlying bonds. Bond funds can be either actively managed (where the manager aims to hold bonds it thinks will outperform the broader market) or index tracking (where the manager simply buys bonds that closely match one of the major bond market indices). and ETFsThe acronym for Exchange Traded Funds. ETFs are funds (unit trust) listed on a stock exchange. Many ETFs are passive index funds, which simply aim to track the performance of major indices (in the asset class being invested in).

With bonds and bond fundsFunds (unit trusts) which invest in a portfolio of underlying bonds. Bond funds can be either actively managed (where the manager aims to hold bonds it thinks will outperform the broader market) or index tracking (where the manager simply buys bonds that closely match one of the major bond market indices). and ETFsThe acronym for Exchange Traded Funds. ETFs are funds (unit trust) listed on a stock exchange. Many ETFs are passive index funds, which simply aim to track the performance of major indices (in the asset class being invested in). that invest in them, interest rate riskThe risk that arises to holders of bonds and other debt securities from fluctuating interest rates. The value of a fixed rate debt security will fall as interest rates rise (and vice versa). The amount of interest rate risk depends on the term or duration of the bond/portfolio of bonds. hinges on duration, or modified durationA measure (expressed in years) of the effect of changes in interest rates on the price of a bond or bond portfolio. The longer the duration, the more sensitive the value of a bond (or portfolio) should be to interest rate changes. to be precise. For an individual bond, duration is a relatively simple concept, for a fund it is more complicated. The basic idea is that duration reflects the amount of interest rate riskThe risk that arises to holders of bonds and other debt securities from fluctuating interest rates. The value of a fixed rate debt security will fall as interest rates rise (and vice versa). The amount of interest rate risk depends on the term or duration of the bond/portfolio of bonds. in a bond, or a portfolio of bonds in the case of a fund – the higher the duration the greater the exposure to changes in interest rates.

A bond or a portfolio with a two year duration doesn’t have much exposure to rising interest rates. However, a bond or portfolio with a ten year duration, has plenty.

To give a real life example, the fixed interest fund in our model portfolios – Schroder Fixed Income Fund – has a duration (at 29 February 2016) of 3.43 years. The bond index it’s benchmarked against – the Bloomberg AusBond Composite 0+Yr Index has a duration of 4.67 years. The shorter duration of the fund compared to the index means it’s taking less risk on rising interest rates – effectively it’s betting (in a relative sense) on interest rates rising in the medium term.

Unlike a term deposit, bonds (and bond fundsFunds (unit trusts) which invest in a portfolio of underlying bonds. Bond funds can be either actively managed (where the manager aims to hold bonds it thinks will outperform the broader market) or index tracking (where the manager simply buys bonds that closely match one of the major bond market indices).) are actively traded, so their market price constantly changes. One of the key factors in price movements is changes in market interest rates.

The impact of movements in interest rates on bond prices

Let’s say you’ve invested $100,000 in a three year bond (or a portfolio of them), paying 4 per cent per annum, or $4,000 a year. Rising interest rates will cause the value of this bond to fall and falling interest rates will see the value increase.

If interest rates rise to 7 per cent a year down the track, your bond will be paying $3,000 less a year than a potential purchaser wants to earn – $6,000 over two years. So a buyer will need to be compensated by reducing the price by this amount (roughly), meaning they’d pay around $94,000 today. In practice, there’s an adjustment for the time value of money but this doesn’t have much impact on shorter term bonds.

It does however have more impact when talking about long-term bonds (or portfolios with a high duration) so this simple approach doesn’t work as well in this context. The adjustment to the upfront bond price compensates for the ongoing ‘income shortfall’ – now extending well into the future – and this needs to be discounted back to today’s dollars.

A good rule of thumb is that with 20 years left to maturity, if you add up the shortfall in income and halve it (three quarters if there’s ten years left) you won’t be far wrong in your estimate of change in value of the bond.

In the above scenario, if the three year bond was a 20 year bond instead it would still pay $3,000 less than the new ‘market rate’ each year, but over 19 years rather than two. Using our rule of thumb, $57,000 (19*$3,000) divided by two equals $28,500. That means the bond would be worth approximately $71,500. So you’ll lose roughly 30 per cent of your principal if interest rates rise 3 per cent and you have to sell out today.

Online bond price calculators, such as the calculator provided by Investopedia, can also be handy for assessing interest rate riskThe risk that arises to holders of bonds and other debt securities from fluctuating interest rates. The value of a fixed rate debt security will fall as interest rates rise (and vice versa). The amount of interest rate risk depends on the term or duration of the bond/portfolio of bonds. on an investment (although be sure you understand how the inputs work). In the above example, the calculator gives a value for the theoretical bond of approximately $69,000, showing that the rough rule of thumb gives a pretty good feel for the potential price movement.

Note the difference between the three and 20 year bonds. They might both be called ‘fixed interest’ but the potential movement (in our scenario) on the three year bond is very small compared to the potential price movement on the longer term bond. From an interest rate riskThe risk that arises to holders of bonds and other debt securities from fluctuating interest rates. The value of a fixed rate debt security will fall as interest rates rise (and vice versa). The amount of interest rate risk depends on the term or duration of the bond/portfolio of bonds. perspective the three year bond behaves more like a variable rate security, or even an online savings account, than it does a 20 year bond.

Building a fixed interest portfolio

So how should you build a fixed interest portfolio? There are three key factors to consider:

  1. Long-term low/falling interest rates. If you think interest rates are heading to zero, and might stay there, a portfolio of long-dated (10 to 20 year) bonds makes sense. Just remember, if interest rates rise, this portfolio’s value will plummet.
  2. Rising interest rates. Whilst they’re important for liquidityAn asset is ‘liquid’ when it can be easily converted to cash. Bank deposits, short term bonds and large listed shares are very liquid. Investments such as property and art aren’t. An investor is also said to be ‘liquid’ when they have plenty of cash and other liquid assets in their portfolio or spare borrowing capacity which allows them to make investments at short notice. Liquidity is a reference to how liquid an asset (or investor) is. to take advantage of opportunities – and great if you pick the future perfectly – building a fixed interest portfolio around short term deposits leaves you highly exposed to rates falling, and sees you miss out on term premiumThe difference between a long-term interest rate on a bond (or deposit) for a particular period and the market's expectation of cumulative short-term interest rates over that same period. It is a function of investors charging for the illiquidity of a longer-term investment. For example, if the market expects six month rates to remain at 3 per cent for the next two years, two year rates might be slightly higher than 3 per cent, reflecting the 'term premium' on a two year investment..
  3. Short-term low/long-term rising rates. If, like us, you think we’re in for a period of low rates but ultimately they’ll rise, then a portfolio of multi-year term deposits, or bonds and bond fundsFunds (unit trusts) which invest in a portfolio of underlying bonds. Bond funds can be either actively managed (where the manager aims to hold bonds it thinks will outperform the broader market) or index tracking (where the manager simply buys bonds that closely match one of the major bond market indices). with a few years duration is the way to go – it’s the approach we’re taking in our model portfolios. This delivers the safety of a few years certainty without much risk. It’s a middle ground approach, which is why we recommend it.

That’s a quick guide to assessing the interest rate riskThe risk that arises to holders of bonds and other debt securities from fluctuating interest rates. The value of a fixed rate debt security will fall as interest rates rise (and vice versa). The amount of interest rate risk depends on the term or duration of the bond/portfolio of bonds. in your portfolio. If you have questions, remember that we’re only a Q&A submission away.

 

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