Investment Insights
Mike Jones
This month let’s take a look at what the open market committee of the Federal Reserve board decided at their June policy meeting.
A year and a half ago the Fed slowly began the process of raising interest rates in order to remove the dramatic accommodation they set in place in the aftermath of the global financial crisis of 2008 – 2009. Many of you are aware that their decisions have a direct impact on bond prices and interest rate yields across the securities market, therefore affecting our portfolios.
The below chart by all Allianz Global Investors, which analyzes the changing profiles that traditional core bonds exhibited 20 and 10 years ago versus today, is very enlightening.
By way of explanation, duration signifies the amount of time it takes to get 100 cents on the dollar back on an investment – including interest payments and principal repayment. This number is significant because of the following rule of thumb: for every 1% interest rates increase in the marketplace, bond prices decline by the duration that they exhibit. For example a $100,000 portfolio would lose approximately $10,000 if it had a duration of 5 years and interest rates went up 2%.
Notice the yield and duration that a diversified, core bond portfolio exhibits today: 2.6% is the interest rate and 6.1 years is the duration. It is no understatement that this creates a problem for bond market investors.
Since duration and principal loss only become an issue if interest rates rise, consider the below from comments from Bloomberg.com on the heels of the most recent federal reserve meeting:
Federal Reserve officials forged ahead with an interest-rate increase and additional plans to tighten monetary policy despite growing concerns over weak inflation.
Policy makers agreed to raise their benchmark lending rate for the third time in six months, maintained their outlook for one more hike in 2017 and set out some details for how they intend to shrink their $4.5 trillion balance sheet this year. Quarterly projections for 2018 and 2019 showed Fed policy makers largely maintained their expected path for borrowing costs.
The median forecast still has the central bank making three quarter-point increases in 2018; the end-2019 rate is seen at 2.9 percent, a slight change from 3 percent in the March projections.
From that same Bloomberg article, below you will see what is called the Fed’s Dot Plot. It shows what each of the seven members of the Board of Governors of the Fed project interest rates to be as time goes by so that one can, theoretically, form a general idea of what rates may be going forward. For our purposes we can see that by and large the board believe that interest rates will rise a little more than 1 ½% over the next two years.
So what does this mean for us? It means that we need to reshape the construction of our bond holdings so that we can have a much shorter duration.
Currently the duration on Argent’s Momentum Select Dynamic Bond portfolio is 2.9 years. Higher interest rates should therefore be less threatening to the principal. This portfolio is also monitored so that any long-term break down would initiate portfolio modifications which would shorten this duration even more.
