The relationship between interest rates and bond prices is a fundamental concept in the fixed income universe.
Specifically, when interest rates rise, a bond’s price will fall by an amount approximately equal to the change in interest rate, times the duration of the bond.
For most investors, the primary importance of bond duration is that it predicts how sharply the market price of a bond will change as a result of changes in interest rates. In other words, investors use duration to measure the volatility of the bond.
For instance, a bond with duration of 5 years would be expected to fall 5% in price for every 1% increase in market interest rates.
Fixed income investors need to be mindful of the strategies that may be employed to protect a portfolio against the threat of rising interest rates.
For the investor concerned with the damaging consequences of rising interest rates, there are a variety of fixed income strategies that may be employed to construct defensively positioned bond portfolios having reduced interest rate risk, while still maintaining adequate cash flow characteristics. A portfolio of short to mid-term maturity, high yield bonds, callable bonds, along with floating-rate securities and having issuers of diverse credit quality would likely do well to provide meaningful levels of coupon payments while offering decent principle protection in an era of volatile and rising interest rates.
While chasing an yield pick-up in your portfolio, put the credit quality of the issuer in the balance before taking an investment decision. As a gentle reminder, the popular adage: “There’s no such thing as a free lunch”!