When rates of interest rise, you may’t sell a bond for the worth you paid, says Will Gornall, an associate professor at UBC’s Sauder School of Business. “Because they are traded, if you have a 3 percent bond and the current interest rate is now 4 percent, no one is going to pay the full price for your 3 percent bonds,” he explained. “You have to sell it at a discount. That discount is duration risk. It’s the risk that if interest rates rise, you won’t be able to sell it for the price you paid.”
According to Gornall, term risk is the downside of if you sign a fixed-rate mortgage and rates of interest go up, but you are protected since you locked within the rate of interest. “If you lend money, of course you’re on the other side of that trade,” he said.
When safer bonds lose value
Bonds are sometimes considered the safer a part of a portfolio, but investors were painfully reminded of duration risk in 2022 as central banks quickly raised rates of interest to combat inflation. As rates of interest rose, bond prices fell significantly, making matters worse for investors, who also saw the equity portion of their portfolios plunge this 12 months – a double blow to their investments.
For investors, the excellent news is that if the worth of a bond you paid for at face value falls because of increased rates of interest, you’ll only incur a loss for those who resolve to sell it before maturity. Andrew Clee, vp at Fidelity Investments, said that so long as the issuer doesn’t default, it’s going to get well the face value of the bond at maturity. “But if you don’t have the intention to hold it to maturity, that can be a real loss,” Clee said.
The duration risk is unrelated to the creditworthiness of the bond issuer. Even government bonds may be affected if rates of interest rise, even when the chance of default stays low.
“Interestingly, government bonds are often riskier in terms of duration risk than corporate bonds or other less safe bonds, simply because the less safe bonds pay more interest and typically don’t have as long a maturity,” says Gornall. “Nobody is going to lend to a company in distress, a company that might default, they’re not going to lend at a low interest rate for 30 years.”
Managing bond risk through duration
To manage duration risk, lively bond fund managers vary the duration of the bonds they hold. When they expect rates of interest to rise, they shorten the duration of bonds in a portfolio to scale back their vulnerability to an increase in rates of interest. However, in the event that they expect rates of interest to fall, they could look to carry longer-term bonds.
Clee says lively bond managers who shortened the duration of bonds of their portfolio in 2022 outperformed the passive market. “I think there was a lot of complacency in the post-financial crisis period through 2021 because we had very low interest rates and a stable bond environment for a very long period of time,” he said.
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