Interest rates have been at historically low levels for approximately 10 years following a period of declining rates for about 20 years since the mid 1980’s. Bond prices move in an inverse direction to interest rates – bond prices increase when interest rates go down and bond prices decrease when interest rates go up.
Duration is the financial term representing a measure of the length of time it takes the cash flow from the bond to repay the investor their principal. The resulting duration amount is the amount by which the market value (price) of a bond would decrease from a 1% increase in interest rates.
As an example, a bond with a 3.5% yield and 5-year maturity has a duration of 4.63. A bond with a 3.75% yield and a 10-year maturity has a duration of 8.43. A longer bond with a 4.0% yield and a 20-year maturity has a duration of 13.95. In other words, if market interest rates increase by 1%, the holder of the 20-year bond in the example would experience a decrease of 13.95% in the value of the bond.
At Windward, our philosophy is that bonds are diversifiers and lower risk assets in our client portfolios. Accordingly, we believe longer term interest rates pose an unnecessary risk in this conservative space in this low interest rate environment. For less risk averse investors, the equity portion of the portfolio is a better place to take risk and invest for gains. Our strategy is to keep our bond fund duration short to medium and not take large interest rate risk with our client portfolios and potentially incur the major reductions in the value of bond holdings noted above.
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