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VM   Corporate Bonds, FAQ   August 16, 2012  

How to Stress Test Your Bonds

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After falling steadily for the last 30 years, interest rates can’t get much lower. Bond investors know that’s reason to worry: When rates rise, bond prices fall. But bond investors needn’t be at the mercy of the Federal Reserve — your fund manager or financial adviser has already given you the tools you need to see how your portfolio will hold up if (or when) rates climb.

The quickest and bluntest way to check a bond’s riskiness is to look at its maturity, the number of years to repayment. Simply, the longer the maturity of your bond, the longer you have to wait to get the principal back, and the more vulnerable it is to an upward move in interest rates which could decrease the price of your bond, fund managers say.

A slightly more complicated gauge is duration, a measurement of a bond’s sensitivity to a change in rates (KMI can provide you with this figure.) There’s no way of knowing exactly how a global change in interest rates will affect the price of your bond, but you can estimate the impact by looking at a hypothetical change in yield, which can be impacted by a change in rates, price and other factors.

To test your bond, multiply its duration by the potential change in yield to get the absolute value of how much the price of your bond would change. Remember an increase in yield means a decrease in price, and vice versa. For example, if the yield on your bond increased by 0.50 percentage points, a bond with a duration of 4 would see its price decrease by 2%, or 200 basis points. A 0.50 percentage point drop would have the opposite effect, bumping up the price by 2%.

A third way to test is to use a bond calculator that can help you estimate how much a change in yield would impact the price of your bond or bond fund. To test a bond, you’ll typically need the maturity and the coupon rate, or interest paid. Plug in the coupon rate, which doesn’t change, and the current price to see what your yield would be if you held the bond to maturity. Likewise, you can type in a hypothetical yield either higher or lower than the coupon rate and see how the price of your bond would change accordingly.

Bond funds behave slightly differently. Because the manager buys and sells several issues, there’s no single maturity, only an average for the portfolio. Same for duration, so when evaluating your holdings, use the averages. To test a bond fund with a calculator, use a hypothetical $100 price so that any changes in the price can be reflected as a percentage change. For example, a change to $80 would signify a 20% drop in the price of your bond fund. Also enter the fund’s average maturity instead of maturity and use the fund’s “yield to maturity” instead of the coupon rate.

So what can you do to protect a bond portfolio against rising rates? The simple answer: Choose bonds with shorter maturities and hence low duration. Of course, it’s never that simple. Most bonds and bond funds are also subject to credit risk, such as a company or municipality defaulting. And the value of a bond fund could also be affected by changes the manager makesl. For instance, a portfolio’s shift away from higher-paying corporate bonds to Treasury bonds would reduce the risk of default, but it would also lower the yields.

sourced from: http://www.smartmoney.com/invest/bonds/how-to-stress-test-your-bond-portfolio-1296243244815/

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