The main factors influencing a bond’s duration are time to maturity and its coupon rate. In general, the longer the time to maturity, the higher the duration. The higher the bond’s coupon rate, the lower the duration, all else being equal. For example:
| ETF | Ticker | Effective Duration | Effective Maturity |
| Vanguard Short-Term Bond ETF | BSV | 2.64 years | 2.80 years |
| Vanguard Long-Term Bond ETF | BLV | 14.13 years | 22.60 years |
An investor in BSV can expect a 2.64% increase in the value of the fund due to a 1% decline in interest rates. Likewise, an investor in BLV could expect a 14.13% increase in the fund as a result of a 1% decline in interest rates. These of are approximations, of course, and don’t include any market or other factors that could influence the price of an ETF over time. Also, duration is an estimate, not a set number.
For clients invested in individual bonds or bond funds, should interest rates decline as many predict, aided by any Fed interest rate cuts, they could experience potentially significant increases in the value of their bonds or bond funds, especially if they are on the longer end of the duration spectrum.
Bond and CD ladders
With interest rates at high levels, this can be a good time to lock in these rates with individual bonds orcertificates where appropriate. Keil, the financial advisor, said that the bond market is telling us to lock in before the Fed starts cutting.
A strategy to consider is building a bond ladder or a CD ladder if that fits into a client’s overall financial planning and investment strategy. Using a ladder allows clients to lock in today’s relatively high rates without worrying about where rates go as long as they hold the bonds or CDs until maturity. While bonds seem to get more press, a recent article by Fidelity indicated that some CD rates are very favorable compared with some riskier bonds.
As each holding on the ladder matures, clients can decide how to reinvest the money. This could be at the longer end of the ladder or elsewhere. In the meantime, clients benefit from the interest earned during the holding period.
Bond Investing Risks
While the Fed has indicated that it will be cutting rates, there is no guarantee as to when these cuts will start and how extensive they will be. Experts’ opinions vary on this topic and also on inflation and the overall economy. Both areas can influence the direction of interest rates.
A risk, especially for clients using ETFs and mutual funds to invest in bonds, is to know when rate cuts have run their course. At that point, the risk, especially with longer duration holdings, is that rates could head back up. That could cause a decline in the value of these funds, potentially eroding some or all of the profits made from price increases fueled by declining interest rates.
Most clients likely have a target allocation for bonds and fixed income within their overall asset allocation. While it can make sense to direct some of this allocation to longer duration bonds or other areas that are expected to benefit from falling rates, it’s important to have a plan associated with any of these changes to realize gains and minimize risk. One option, if longer duration bond ETFs are being used, is to use stop orders to minimize the downside potential should rates head back up.
Longer duration ETFs, mutual funds or individual bonds could trigger capital gains when sold after a significant interest rate decline. Planning should take this into account. If there is latitude in a client’s accounts, some consideration should be given as to where to hold these assets in order to minimize the tax hit from these gains. This could also be a factor in portfolio rebalancing over the next couple of years.
The current environment looks very favorable for bonds. Your guidance can help clients benefit from the current situation while not straying from their long-term investment strategy.
