One way to gauge the impact of interest rates on bond prices is to calculate the duration* of a bond or bond portfolio. Duration is expressed in years and can be used to calculate the approximate change in a bond’s price as interest rates change. The duration of the bond portfolio owned by all MCS clients, for example, is about 6.2 years. To estimate the impact of interest rates rising 1%, we can simply multiply the change in interest rate by the duration of the portfolio: +1% x 6.2 duration = –6.2% price change; bond prices would go down 6.2% (remember, bond prices fall as interest rates rise). If the interest paid on the bond portfolio was 5%, the total return on the portfolio would be 5% (interest) minus the price change of 6.2% = –1.2%.
*Duration is not the only factor that affects bond prices. Next newsletter I’ll discuss how spreads — the extra yield paid for lower credit quality — may reduce the impact of higher interest rates on bond prices.