With the threat of rising interest rates resulting from the Federal Reserve unwinding its bond-buying program —quantitative easing round 3 in which the Fed has been buying $85 billion in bonds each month since September — investment values that fluctuate as a result of changing rates are at risk of price declines. For those who own these investments, understanding the possible downside risk, given a specific increase in interest rates, can help provide actionable information.
Investments that incur a change in price when interest rates change have various characteristics that influence the magnitude of that change, given a change in rates. For example, if interest rates rise, bonds will experience varying price changes based on maturity, coupon rate, call features, issuer, quality rating, etc.
All other characteristics being equal, bonds with longer maturities fluctuate more with a given change in interest rates than bonds with shorter maturities. For example, a U.S. treasury with a maturity of five years will move less, given a specific move in interest rates, as compared with a 30-year U.S. treasury. This is due to the timing of the receipt of cash flows — the longer it takes for the investor to receive the cash flows from the bond, the more volatility the bond will experience for a given change in interest rates.
It follows then that the lower the coupon, the more volatility a bond will experience, again, all else being equal. This is because the investor will receive less of the total cash flows from the bond — coupon payments and the return of principal at maturity — during the life of the bond, the lower the coupon rate. From this we can see that zero-coupon bonds will have the most volatility for a given maturity, all else being equal.
By now you may be saying to yourself; this is getting complicated! Unfortunately, calculating the expected change in a bond, or any investment, given a change in interest rates, can be complex. However, it is helpful to understand (at least) that the longer it takes to get back your expected cash flows, the more volatile an investment will be, with a given change in interest rates. Call features or early payoff/payback features of investments will lessen volatility because they offer at least the potential to receive cash flows earlier.
From a quality standpoint, the lower the quality, the more the volatility. A CCC-quality corporate bond (a junk or high-yield bond) with the same coupon rate as a AAA corporate bond, both with the same maturity, will be more volatile with a given change in interest rates. In other words, if rates rise, the lower-quality bond will decline far more in price than the AAA bond.
The only way to effectively reduce bond price volatility is to shorten maturities. Historically, it is very difficult to forecast the direction of interest rates. However, we are in a very unique environment — we know that interest rates are about to increase dramatically, since the Fed will begin to taper off its bond-buying program by the end of this year. Rates will increase as the Fed removes stimulus from the economy, so we know that all investments that are sensitive to interest-rate changes will be negatively affected, including all bonds.
The following table summarizes the expected change in price for U.S. treasuries of varying maturities, given increases in interest rates ranging from 1 percent to 5 percent. This table reflects the changes that would be expected, based on all bonds currently priced at par, or 100 percent given today’s yield curve. Investors can use this table to compare their investments to the changes that would occur to treasuries, given the range of interest-rate increases. By comparing maturity, quality, issuer, coupon, call features, etc., investors should be able to make a reasonable estimate of possible price declines for their bonds.
For real estate investors, capitalization or cap rates are affected not only by mortgage rates — the cost to finance the purchase of the property — but by interest-rate changes that affect the availability of capital and the demand for investment. These capital flows influence the supply and demand for property and, as a result, they affect property prices. In addition, interest rates also affect returns on substitute investments, and prices change to stay in line with the inherent risk in real estate investments. Changes in required rates of return for real estate also vary during periods of destabilization in the credit markets. As investors foresee increased variability in future rates or increases in risk, risk premiums widen, putting increased downward pressure on property prices. Cap rates must rise in a rising interest-rate environment, to compensate real estate investors for the added risk they must take.
Rising cap rates, in a general sense, pressure real estate prices as investors demand a greater return for the perceived increased risk in a rising interest-rate environment. A cap rate is calculated by taking NOI (net operating income) and dividing that by the current value or the proposed purchase price of the property. If an apartment building priced at $1 million generates $100,000 in annual income, the cap rate would be 10 percent. Because real estate prices have risen so dramatically in recent years, even with the correction we have experienced in real estate, cap rates, depending on property type — retail, office, multihousing, etc. — are between 4 percent and 6 percent. This cap rate range means that for a property generating $100,000 in NOI, the price should be about $2 million ($100,000/$2 million = 5 percent).
If interest rates rise, cap rates must rise as well. In our example, with a property generating $100,000 in NOI, the following table outlines the change in expected property value, given a range of cap rates:
As with bonds, there are many factors that affect property values. The table above provides a general overview of the impact of changes in property values, based on changing cap rates to assist investors in understanding the possible price reactions to changes in interest rates.
Other investments, such as stocks and commodities, will be negatively affected by rising interest rates. Stocks typically can perform well relative to other investments in a rising rate environment, as long as the pace of rate increases is reasonably slow and the rate increases do not stifle economic activity. It remains to be seen whether the Fed can taper off its bond buying, allowing long-term interest rates to rise, without causing serious economic damage.
Regardless of the type of investments owned, investors should understand the potential for price declines within their portfolio, and should look to effectively and proactively make adjustments to their portfolios to reduce this risk.