The typical term structure of interest rates translates into an upward sloping yield curve, where investors are paid higher yields to part with their money for longer periods of time. That structure currently exist with the 10-year Treasury yielding 2.81% higher than the 2-year Treasury.  Higher yield is better right? There is no “free lunch”… So what’s the tradeoff?

Yield is an assumption of future performance based on the income stream provided by the bond and the price paid for that income stream. Even without considering default, it is not a gurantee of annual performance, because the ever-changing yield environment effects the price of the bond from period to period. Duration is used to measure how sensitive the market price of a bond is to a given change in interest rates.

Source: Acropolis

Duration can act like a lever. Magnifying gains when interest rates drop and losses when interest rates rise. If the figure above was changed to show a drop in rates, the scales would be tipped in the other direction, making the 10-year duration bond outperform the 2-year.

Some will argue that the price fluctuation due to interest rates isn’t permanent, so it isn’t important. It is true that regardless of interest rate volatility, the investor will earn the purchase yield if the bond is held to maturity, but there is more to the overall story. Investors that say they can hang on for a bumpy ride, and ignore price fluctuation in exchange for higher yields, are ignoring the power of reinvestment. When rates rise, opportunities to reinvest become more attractive, and can significantly impact performance over time.

Source: Acropolis

If you consider the same two bonds, a two-year at 2% and a ten-year at 4.5%, in an environment where rates increase one percentage point per year for 4 years, you can see the positive effect of having money to reinvest sooner. The strategy of continually reinvesting in the two-year bond over the ten years outperforms on an absolute basis by about .3% per year, despite yielding 2.5% less than the ten-year at the onset. If you consider price fluctuation, which I left out of the above figure, the ten-year duration bond has a negative total return as late as 3 years into the investment. Given that scenario, time-horizon is another important factor to consider. Having to raise cash in a rising rate environment means realizing losses in what many consider to be the part of the portfolio where capital preservation is the number one goal.

This is of course not the only possible interest rate environment.  Finding proper value in bonds includes analyzing a collection of possible environments and assessing how differing levels of risk will affect performance given the most likely outcomes. I chose this particular environment to show how interest rate movements can still negatively affect performance despite holding bond until maturity.

Have a great weekend,

Cliff J. Reynolds Jr., Investment Analyst