Interest Rates, CPI, and Duration
We have been saying for some time now that we believe interest rates would rise. For readers of this update on a regular basis, this has been a consistent theme that we believe should be an important consideration as fixed income assets are invested. In advance of potential interest rate increases, Destination Wealth Management is focused on investing assets with the recognition that duration statistics is an important consideration.
With the 10-year treasury now climbing in terms of annual yield, it appears that interest rate increases are finally here. Both bond and equity markets are anticipating that inflation is percolating throughout the economy and will likely require the Federal Reserve to raise interest rates. For DWM this is neither unexpected or alarming. Because of our perspective that interest rate increases were likely inevitable, we’ve intentionally positioned fixed income strategies in anticipation of possible higher inflation and rate increases.
Why Do Bond Prices Fall as Rates Rise?
I am often asked why fixed income values fall when interest rates increase. It is simply a matter of expectations for future cash flows. If one owns a 10-year bond locked in at 2.5% and interest rates increase, the value of that bond likely will fall as it is less valuable as rates rise. A 10-year bond paying 2.8% is more valuable than the 10-year bond paying 2.5%. That value is reflected in the current price of the 2.5% bond; the market simply depreciates the value of this bond to reflect it’s worth relative to the higher-yielding instrument.
Not everyone has maintained a perspective that duration considerations are important. Huge flows of money moved into longer-term duration assets in the last several years without any consideration of the potential interest rate risk associated with long maturities. Some have clamored for yield without considering the potential volatility associated with interest rate increases and that likely will result in unwelcome surprises in capital values for holders of these type of positions.
The statistic that matters most to us is duration. Duration is a calculation that measures the potential interest rate fluctuation based on the yield received relative to the amount of time required to hold an instrument to maturity. It is a statistic that we assess regularly and we manage fixed income towards a target duration dependent on our view of potential inflation and rate increases. Duration is a consistent topic of discussion in our ongoing portfolio management meetings.
As DWM manages fixed income assets, we believe it is important to carefully assess data that can impact bond positions and this topic is a significant component of our investment discussions on a regular basis. Even if portfolio strategies do not have fixed income as a part of an overall allocation (and most of our portfolios do have fixed income as a component), we still believe it is wise to carefully watch the direction of interest rates as an indication of future potential economic activity. Economic activity can impact not only equity investments but overall allocation strategies.
Behind the scenes, every day we are watching and assessing information, market data, economic statistics, and a variety of other inputs as we manage portfolio strategies. Duration is one of those data points that we monitor and assess.
If you have any questions about this information, do not hesitate to let us know. Thank you!