Note from Our CIO: Bonds and Rising Interest Rates

Our Investment Committee meets regularly with the aim of making sure our portfolios are properly positioned to protect client wealth from unnecessary risks and to capture appropriate returns from the world’s capital markets. At a recent meeting, we made some adjustments to our bond strategy.

The bond portion of your portfolio has the primary objective of preserving capital. As a bond investor, you are lending your money to borrowers (governments, corporations and homeowners) with the expectation that you will get your principal back, plus interest along the way, in a more predictable and reliable manner than a stock investment; due to this lower-risk expectation, you earn only a modest interest rate. However, if you are earning 2% on $100 you lent out for four years, and if interest rates rise from 2% to 3%, then the value of your hypothetical $100 bond investment will drop to $96, because you only have a 2% bond while someone else can now lend $100 and get 3%.

As you can see, bonds work mathematically: When interest rates go up, bond prices go down. The amount the bond goes down is what we call its interest rate risk, which is best measured by its “duration.” The duration of the bond is very similar to its maturity for most bonds, and is measured in units of years. So, a bond with a four-year duration means that for every 1% rise in interest rates, the bond’s price will drop by 4%.

In our last Investment Committee meeting, we reduced the duration of our model bond portfolio by half a year, from 4.3 years to 3.8 years. We feel that a rise in interest rates is one of the bigger risks our clients face—in our view, a greater risk than an increase in inflation. TIPS, or Treasury inflation-protected securities, previously made up 20% of the bonds in most of our portfolios, primarily for their protection against rising inflation. Unfortunately, the protection against long-term inflation using TIPS requires taking on significant interest rate risk. To avoid that, we shifted 10% of our bond allocation from TIPS to short-term bonds, thus reducing interest rate risk. However, we were able to preserve the yield of the overall bond mix by moving into a fund that owns more corporate bonds than government bonds (which is what TIPS are).

We believe that this is the most prudent blend of risk and reward for the bond portion of your portfolio, which is there both to provide a positive return in excess of inflation over a full market cycle, and to help your diversified portfolio weather the corrections that negatively impact stock and real estate market values from time to time.

Regards,

Darius Gagne, PhD, CFA, CFP^®, MBA
Partner and Chief Investment Officer