Besides, let's not forget Chairman Greenspan doesn't actually set rates; the market does. He, or rather the Federal Reserve Board, uses monetary policy to influence the path of rates.

But let's set aside your prognostication and the workings of the Fed and concentrate on what would happen if rates should rise for any reason.

What happens when interest rate rise

Generally, whenever interest rates rise, it's a bad thing for bonds, whose prices fall.

The reason is simple. Let's say you pay the $1,000 face value for a newly issued bond that has a coupon rate of 4 percent per year. That means that you would receive $40 in interest payments each year, plus you'd get your principal back at the end of the bond's term.

Now, let's suppose that the day after you buy your bond, interest rates increase by one percentage point so that newly issued bonds of the same quality as yours now carry a coupon rate of 5 percent. And let's further assume that, for whatever reason, you decide to sell your bond. Do you think you could get $1,000 for it?

Not bloody likely. After all, why would anyone give you $1,000 for a bond that will pay them $40 a year when they can get a new bond that will pay them $50 a year? You can't change the coupon rate on your bond. That's fixed -- which is why bonds are often called "fixed-income" investments.

So the only way you could convince someone to buy your bond is by selling it to him for less than a thousand dollars. Specifically, you'd have to cut the price of your bond low enough so that the effective return on your bond at the lower price between now and the time your bond matures, or is repaid, (what's known in bond circles as yield to maturity) would be equal to that of the bond with a 5 percent coupon rate.

The size of the haircut your bond would have to take depends on two things: the bond's maturity and its coupon rate. The longer the bond's term, the more its price sinks when interest rates rise; and the lower the bond's coupon rate, the harder it's hit by climbing rates.

Duration

There's a statistical measure that takes both these factors into account that gives you a good idea of how far the value of your bond (or bond fund) will fall if rates rise. That measure is called "duration." The higher a bond's duration, the farther its price will drop when rates rise.

What's really neat about duration, though, is that once you know what it is for a specific bond or bond fund, you have a pretty good idea of just how much a rise in rates will drive down your investment's value.

Here's how it works. Let's say your bond fund has a duration of 5 years. That means if interest rates go up one percentage point, your bond fund's value would drop by about 5 percent. If duration is 10 years, a one-percentage point rise would knock about 10 percent off the value of your bond fund.

Should rates go up two percentage points, a bond fund with a duration of 5 years would lose roughly 10 percent of its value. Should rates fall, you'd get the opposite effect. Pretty cool, huh?

Checking on your fund

So all you've got to do is first plug the ticker symbol for your bond fund into the "Quotes/Reports" box that appears at the top of virtually every page of the Morningstar Web site. When the Snapshot Report for your fund pops up, just click on the "Portfolio" link that appears on the left side of the page and: TA DA!

Right at the top of the page you'll see your bond fund's average effective duration listed. I checked out a few and most came in between three and five years. That's lower, by the way, than the duration you would find for investment-grade bond funds with similar maturities, the reason being that high-yield bonds have higher coupon rates than higher-quality bonds.

As you go through this exercise, keep in mind that just because high-yield bonds generally have lower durations, it doesn't mean they're less risky.

The prices for high-yield, or junk bonds as they're better known, may also go down if the financial condition of the company deteriorates, if the economy heads south or if stock prices decline. The risk of default -- that is, the bond issuer not making payments as promised -- is definitely higher with junk bonds than investment-grade bonds, which is one reason I always recommend making junk issues a minor player in one's bond portfolio.  

Call Today!  (800) 424-9377

Back to Mortgage Resources