From Alexander Weis and Gerd Kommer
Real estate, bonds (including bank deposits) and stocks form the foundation of most private investor portfolios. In this blog post we look at the risks of bonds – government bonds and corporate bonds – and specifically interest rate risk.
There are essentially three possible sources of bond risk: foreign currency risk (exchange rate risk), default risk (credit risk) and interest rate risk. We looked at currency risk in our blog post “Currency hedging: when does it make sense and when does it not?“We will address the risk of default in a future article.
In the case of bonds, if they are to take on the role of a “risk anchor” in a systematically structured portfolio, the three risks mentioned must be reduced to a minimum or even, if possible, to zero.
The currency risk can be completely eliminated by limiting yourself to bonds in your “functional currency” (“home currency”) or to foreign currency bonds with an exchange rate hedge. The risk of default can be reduced by selecting securities with a high credit rating and through diversification. The interest rate risk remains. This can be reduced very significantly by limiting it to bonds with short remaining terms.
What exactly is interest rate risk? In general terms, it is the risk of adverse wealth effects resulting from changes in interest rates. More specifically, and related to an investor's position, it is the risk of losses in bond prices that can occur if market interest rates rise. For private investors, interest rate risk is likely to cause the most problems of understanding among the three bond risks.
To understand the interest rate risk issue, let's briefly look at a little simple bond math. The central concept here is the negative or inverse relationship between the rate (the price or value) of bonds and the change in the level of market interest rates: All other things being equal, an increase in the market interest rate leads to a decrease in bond prices, and a decrease in the market interest rate leads to an increase in prices. We will illustrate why this is so using the following fictitious example:
Assume that the market interest rate for ten-year federal bonds on January 1, 2020 is 1% p.a. a. and on this day the Federal Republic of Germany issues a bond (Bond A) with an annual coupon (annual interest payment) of 1% and a term of 10 years. In this simple case, the market will “price” this bond at exactly 100 euros on the issue date. Let us also assume (however unlikely) that one day later on January 2nd, 2020 the market interest rate suddenly rises to 2% and that on the same day Germany issues a new bond (Bond B), which also has a term of 10 years, but a coupon of 2% p.a. a. pays. Bond B is also traded on the market for 100 euros because the coupon paid corresponds exactly to the new market interest rate.
Since the newly issued bond B has a more attractive coupon of 2% than the bond A issued the day before (which has almost the same remaining term) with only a 1% coupon, the market value of bond A must fall so much that investors are indifferent between the two bonds; In this example, this would be the case at a rate of around €91. For the sake of simplicity, we will not present the underlying calculations here (see the Wikipedia article via bonds.)
Our example illustrates that a rise in interest rates must lead to a fall in bond prices. There is a simple rule of thumb that can be used to estimate the expected extent of market price changes as a result of changes in interest rates. It is as follows: If market interest rates rise or fall by X%, the market price of a bond falls or rises by X × Y%, where An example: Interest rates rise from 2% to 3% and the remaining term of a bond is 15 years. In that case, the price of the bond will fall by approximately 1% × 15 = 15%. (However, this rule of thumb only applies approximately, it only works for relatively small changes in interest rates and only for bonds that have low coupons. However, these are requirements that are currently being met in practice. This said rule of thumb results from the concept of the so-called modified duration (see the Wikipedia article about bond duration.)
The interest rate risk of a bond can be eliminated to a certain extent by holding it until maturity and if the investor is indifferent to fluctuations in value in the meantime. At the end of the term, you will always be paid back the so-called nominal value originally promised (subject to default by the bond issuer). You can take advantage of this circumstance, for example, if you already know today that you will need a certain amount of money at some point in the future. Then you can simply purchase a bond with a face value equal to the required amount and the same maturity date. In technical jargon, this concept is called “asset-liability matching” and is used, for example, in the investment portfolios of capital-forming life insurance companies: for a payment obligation of 1 million euros in ten years, an insurance company buys a bond today that will mature in ten years and then pays 1 million euros. This concept is likely to be of limited interest to most private investors, as the money invested cannot be touched over the entire term, otherwise it would again be subject to the usual market price fluctuations and because most people cannot ignore the price fluctuations until maturity anyway.
At this point we must briefly discuss the special case of bank deposits. Finally, an investor could now object that the interest rate risk of bonds, especially in the short term, can be easily and completely avoided by using bank deposits instead of a short-term bond (call money, fixed-term deposit, savings account, etc.). Yes, there is indeed no risk of interest rate changes with bank deposits, but this advantage comes at the price of a high risk of default. Because of this risk, bank deposits are generally only suitable for rational investors up to the upper limit of the state deposit insurance or for very short-term parking of money until a less risky form of investment has been found. The upper limit in question is 100,000 euros per depositor-bank combination (state deposit protection). We explained why the risk of default on bank balances beyond this limit is unacceptable in our recent blog post “The underestimated risk of bank deposits“ shown.
Back to bonds and a real example of interest rate risk: The Republic of Austria issued two different bonds on September 12, 2017. One with a remaining term of five years and a coupon (annual interest payment) of 0.0% and one with a remaining term of an impressive 100 years and a coupon of 2.1%. Since market interest rates have fallen slightly (as of the end of November 2019) since these securities were issued (as of the end of November 2019), the prices of both bonds have risen as expected - that of the five-year bond by almost 1%, that of the 100-year bond by a spectacular 73% (as of the end of November 2019). This case illustrates two things. Firstly, that there is an inverse relationship between changes in market interest rates and the return on bonds, not only in theory but also in reality, and secondly, that this becomes more pronounced the longer the remaining term of a bond is. In summary: When interest rates rise, bond prices fall and vice versa. This effect is stronger for bonds with a long remaining maturity than for those with a short remaining maturity.
If one assumes a “normal” interest rate level, which is e.g. B. can be derived from the average of real (inflation-adjusted) interest rates over a sufficiently long historical period, then the low interest rates today imply that bonds are currently highly valued. That's why specialist articles often talk about the "bond bubble" - after a global interest rate reduction trend that lasted almost 35 years from the early 1980s to 2016. The basic principle applies: low interest rates go hand in hand with a high valuation of the bond market, high interest rates go hand in hand with a low valuation.
In general terms: Each asset class has a specific valuation level at a given time; the higher the valuation level, the lower the “expected returns” in the future, i.e. the average returns in the next few years until the valuation level normalizes. For bonds, the so-called “current yield” (yield to maturity) is the expected return and is therefore particularly easy to determine.
It has now become clear to the general public that the asset class of residential real estate in the large cities of the DACH countries is now rather highly valued (see, for example, the recently published study “UBS Global Real Estate Bubble Index 2019From the comments in this blog article, we now know that bonds are also highly valued, i.e. “expensive”. Only the equity asset class in the form of the global stock market is currently relatively close to its fair valuation level (the explanations and figures in our blog post “Overvaluation of the stock market – what to do?"as of June 2018 are still valid today). There is no sensible, generally accepted method for determining the valuation level for gold (see also our blog post “Gold as an investment – do you need it?”). For raw materials (excluding precious metals), the valuation level is likely to be rather low today.
The fact that has not yet reached the general population is that
“Zero interest rates” are not new, but have often occurred over short and long periods in the world's wealthiest countries with high legal security and high creditworthiness over the last 120 years. In our blog post “Zero interest rates and investment shortages – real or just constructed?". However, we will continue to hear the opposite - "today's 'zero interest rates' are something completely new and unique" - incorrectly from the media or clueless politicians for years to come.
Since nominal and real interest rates in all Western countries are currently extremely low and - for government bonds from countries with the highest credit ratings - even negative, and since all Western central banks have been pursuing a loose, expansionary monetary policy for several years, it seems unlikely to us that interest rates will fall any further. On the other hand, we think it is plausible that they will increase again in the next few years.
To take up our example of 100-year Austrian government bonds again in this context: If the market interest rate rises by two or three percentage points, a price loss of over 90% can be expected for this extraordinarily long-term bond.
Conclusion
Given the current rather high interest rate risk, how should a bond portion of the portfolio that serves as a risk anchor be protected from an impending rise in interest rates? The best way to do this is to limit yourself to short-term bonds with a high credit rating in your home currency. The remaining term of the bonds should be as short as possible because short-term bonds suffer much less in the event of a rise in interest rates and will absorb the higher interest rates much more quickly than long-term bonds. If you have a portfolio of many bonds, e.g. B. for one or more bond ETFs, the average remaining term is decisive.
The fact that high-quality short-term bonds currently produce zero or negative returns should not deter anyone from this approach. After all, this investment is primarily about security and only secondarily about returns and secondly because real interest rates close to zero have been the norm for “risk-free” investments for most of the last 120 years.
literature
Holzhey, Matthias; Skoczek, Maciej; Hofer, Katharina (2019): “UBS Global Real Estate Bubble Index 2019”; UBS Switzerland AG, Zurich; Internet reference (last accessed on October 15, 2019): https://www.ubs.com/global/en/ubs-news/r-news-display-ndp/en-20190930-grebi-global.html
Kommer, Gerd; Weis, Alexander (2019): “Gold as an investment – do you need it?”; blog post; November 2019; Link: https://www.gerd-kommer-invest.de/gold-als-investment/
Kommer, Gerd/Schweizer, Jonas (2018): “Better understanding the risk of direct investments in real estate”; blog post; August 2018; Link: https://www.gerd-kommer-invest.de/das-risk-von-direktinvestments-in-immobilien-besser-verstanden/
Kommer, Gerd; Schweizer, Jonas (2019): “The underestimated risk of bank deposits”; blog post; August 2019; Link: https://www.gerd-kommer-invest.de/risk-von-bankguthaben/
Kommer, Gerd; Schweizer, Jonas (2018): “Overvaluation of the stock market – what to do?”; blog post; June 2018; Link: https://www.gerd-kommer-invest.de/uebervaluation-des-aktienmarkts/
Kommer, Gerd; Weis, Alexander (2018): “Zero interest rates and the investment crisis – real or just constructed?”; blog post; April 2018; Link: https://www.gerd-kommer-invest.de/nullzinsen-und-anlagenotstand/
Kommer, Gerd; Weis, Alexander (2018): “Currency hedging: when does it make sense and when does it not?”; blog post; January 2018; Link: https://www.gerd-kommer-invest.de/wann-ist-waehrungsabsicherung-sinnvoll/