In recent years, the bulk of investors’ attention has been seized by the rising equity markets. The fixed income markets’ low yields and the expectations this would persist for the foreseeable future struggled to draw attention away from equities. In our view, this allowed complacency and a false sense of security to creep into fixed income markets. The recent move higher in interest rates has exposed the underappreciated risks present in the fixed income market.

The 10-year Treasury yield reached its closing low for 2020 of about 50 basis points (bps) or 0.50% in early August. Since then, it has moved higher and ended February at about 1.4%. While this rate remains historically low, the more than 2.5X increase is large. If the 10-year had started at 4%, an equivalent increase would result in a 10-year Treasury yielding close to 11%, a level not seen since the early 1980s.

The rate increase results in a drop in the value of bonds, because the coupon interest they pay becomes less competitive. For example, assume a corporation issued a 10-year bond in August 2020 at $100 paying a 1% coupon (approximately 50bps above the equivalent treasury). If the same corporation issued bonds now, it would have to pay close to 2% to keep the same spread above the treasury. That means the bond issued in August is no longer worth $100, because it only pays a 1% coupon, and a buyer could now get a 2% coupon for the equivalent risk.

The August bond will fall in value by the amount required for the investor to get the equivalent of the 2% coupon via the original 1% coupon plus the bond appreciating from today’s lower price to $100 upon maturity. This calculation is the Yield to Maturity (YTM). Both the current bond and the bond issued in August now have a YTM of 2%. The current bond pays a coupon of 2% and matures at the purchase price of $100. The August bond pays a 1% coupon plus the appreciation in value from today’s lower price ($90) to $100 at maturity. In both cases, the investor earns the same amount of money.

The longer a bond’s maturity, the more sensitive its price to changes in interest rates. In our example above, if the bond had 10 years to maturity, the August bond must make up 10 years of below market coupon payments with a lower price. Now if the August bond were 20 years to maturity, it would have to make up twice as many below market coupon payments and thus depreciate even more. This sensitivity to interest rates is called the bond duration, and the longer the bond maturity, the higher the duration. Duration is typically termed in years.

We have kept our bond portfolios short (duration) and high-quality for an extended period. When discussed at our investment committee meetings, we consistently came to the same conclusion – interest rates are not high enough to justify increasing the duration. In other words, we did not feel an investor was paid enough to take on added duration risk. For example, on the treasury side, we have generally used a short-term exchange traded fund (ETF), which invests in treasuries with a 1-to-3-year maturity for a duration of 2. The YTM on the 1-to-3-year treasury ETFs is about 13bps. If we wanted to pick up more yield in the treasury space, the most aggressive position would have been to buy a 20+ year ETF and get a 2.2% YTM but take on the added (principal) risk associated with a duration of more than 18 years.

While 2.2% is much higher than 13bps, the change in value of the underlying securities since the 10-year treasury low demonstrates the risk well. Since August, a 1-to-3-year treasury ETF has a 0% return after including coupon payments. A 20+ year ETF is down over 16%, even with the higher YTM.

Although fixed income holdings are down since interest rate lows in the summer, our decisions to keep duration short and emphasize quality minimized the damage of rising rates.