View How Sensitive ‘Convexity’ Bonds are to Interest Rate Changes

Interest Rates ImageBond prices tend to move in accordance to changes in the overall interest-rate environment with varying degrees of sensitivity. This trait, known as convexity, represents how dramatically a bonds price will respond to a change in interest rates, given its current price point and coupon payment schedule. What’s important to recognize about this aspect of a bond is then that the bond markets are currently priced in a way which makes them particularly sensitive to interest rate changes, given the low interest environment, and high premium being placed on relatively ‘risk free’ assets.

By taking a moment to visualize how a change in interest rates will impact the various fixed income positions in our portfolio positions, we can take a moment to step back and decide whether or not it is time to diversify out into some different kinds of asset classes for additional stability.

By looking at a general portfolio of reasonably low-risk government bonds, we can break down the impacts of various rate changes on the value of the portfolio. While the results aren’t settling, it’s interesting to notice how it is that USA bonds are some of the most sensitive right now. This should grab additional attention based on the fact that the US Federal Reserve is aggressively intervening in bond markets, and pushing interest rater lower artificially.

The end result is a situation where a particularly sensitive asset is being exposed to external price support, and is therefore at the mercy of the Fed for its valuation basis. As soon as the macro-policies shift closer to equilibrium interest rate points, there won’t be much to stop these portfolios from losing anywhere up to 40% of their value as quickly as overnight.

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While the chart included illustrates how it is that various bonds would react to different interest rate adjustments, the important thing to remember is that each of these countries manages their own respective interest rate regime in accordance to their own respective economies. This means that an increase in the US does not necessarily mean that the UK or Germany will increase their rates. In fact, there are often situations where we can see that losses in bond prices from one country will result in gains for others as a result of the capital fleeing the nation-specific risks as opposed to the global risks.

The end result is that savers holding a diversified fixed income portfolio would not actually see a major decrease to their portfolio value as the result of a single decline in value from a particular asset, so long as: 1) the decline is not globally pervasive, and 2) the decline is not the result of an actual default on the payments themselves. So long as these criteria are not met, then a fixed income portfolio (particularly one that is held to maturity) is still about as safe as it was when it was first built.


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