Last Updated Dec 13, 2010 10:51 AM EST
Some investors have been so concerned about interest rate risk that they've kept their fixed income allocation in either money market accounts or very short-term fixed income securities. Let's explore the interest rate risk characteristics of high-quality fixed income securities and funds. This should provide a better understanding of the risks embedded in fixed income and how it could impact total portfolio risk.
Interest Rate Risk
For high-quality fixed income portfolios, interest rate risk (a measure of the potential loss on your fixed income holdings) is primarily dependent on two factors:
- Maturity -- All else equal, you have more exposure to interest rate risk as the maturity of your fixed income holdings lengthens. If you double the average maturity of your fixed income portfolio, you roughly double your exposure to interest rate risk.
- Volatility -- The more volatile interest rates are, the more exposure you have to interest rate risk. If interest rate volatility doubles, then so does interest rate risk.
- It's important to note that if your fixed income holdings have substantial default risk, that must be considered as well.
Estimating Prospective Volatility One of the best (but by no means perfect) estimates of prospective volatility of fixed income securities is recent historical volatility. The following are the annualized volatilities of returns for three of the fixed income funds we commonly use, for the 12 months ending October 2010.
- DFA Two-Year Global Fixed Portfolio (DFGFX) -- 0.7 percent
- DFA Five-Year Global Fixed Portfolio (DFGBX) -- 2.8 percent
- DFA Inflation-Protected Securities Portfolio (DIPSX) -- 5.3 percent
Another way to think about the risk of potential loss from investing in these funds is a fixed income concept called duration, which is closely related to average maturity. Duration simply represents the expected percent loss if yields were to go up by 1 percent. Yield is a rough approximation of the annual percent return that you can expect to earn on fixed income investments that are essentially free of default risk. When yields go up, fixed income returns go down.
The three funds mentioned above have durations of:
- DFGFX -- 1.4
- DFGBX -- 3.8
- DIPSX -- 7.9
Interest Rate Risk From a Total Portfolio Perspective To put the historical volatilities into context, the annualized volatility of the S&P 500 Index for the same time period was 19 percent or roughly 27 times more volatile than DFGFX, approximately 7 times more volatile than DFGBX and about 4 times more volatile than DIPSX. At the portfolio level, this means that interest rate risk will be dwarfed by equity risk for any substantial allocation to equities (for example, 50 percent or more of the portfolio allocation).
The Potential Costs of Ultra-Short-Term Fixed Income By sticking with ultra-short-term fixed income securities over the last couple of years, investors have essentially eliminated interest rate risk but given up substantial returns as a result. For example, three-month Treasury bills have earned total returns of about 0.6 percent from October 2008 through October 2010, while three-year Treasuries have earned total returns of about 10.2 percent. The cost of cash was substantial over this period, and the trade-off between interest rate risk and this potential cost should factor into any fixed income allocation decision.
Summary Interest rate risk is a concern when constructing a fixed income portfolio. However, it's important to understand the magnitude of this risk, which is low in an absolute sense for the fixed income securities and funds we use. It's also low relative to the volatility of equities. In a steep yield curve environment, one must also keep in mind the fundamental trade-off between interest rate risk and the potential cost of ultra-short-term fixed income securities.
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