The risk of rising interest rates
To illustrate the impact of an increase in interest rates on the portfolio result, let’s look at the following example. Let’s consider a newly issued 10-year German Bund with a coupon rate of 3%. If interest rates were to rise from 3% to 4%, the price of the 3% Bund will drop to a level at which this government bond offers a return near the recent market rate of 4%. After all, investors are able to get a 4% market rate and want to receive no less than that market rate on an issued bond. As the maturity date approaches, the price of the 10-year 3% Bund will gradually increase to 100% (equal to the principal amount to be repaid).
Rising interest rates can be harmful, as they can lead to capital loss. We saw this last year, when the Federal Reserve announced its intention to conditionally reduce its monthly Treasury bond purchases. No matter how carefully the U.S. central bank chose its words, the announcement led to a significant rise in long-term rates. An interest rate rise of 15 basis points leads to a capital loss of about 1% on a 10-year U.S. Treasury. In 2013, 10-year Treasury yields rose by 129 basis points, resulting in a 7.83% (in USD) loss for investors in these bonds.
This event did make fixed income investors wakeful. If we look at the past 30 years, these kinds of losses on US Treasury bonds and German Bunds are extraordinary, but it is not unlikely that such upward interest rate movements will occur more often in the future. In short, the reward for investing in fixed income could at some point come under more pressure. Let’s take a closer look at this reward.