Just how far will your Treasuries fall if and when interest rates rise?
I know many of you are wondering this, because I’ve recently received several emails asking me this very question. On the one hand, you already know that rising interest rates cause bond prices to fall. But, on the other, you don’t know how to calculate the actual magnitude of those losses.
This is important for various reasons, but one of the most crucial: You may be exaggerating the losses you would incur in a rising-rate environment. If so, that in turn could be leading you to unnecessarily (and unwisely) shun Treasuries in your portfolio.
Consider, for example, a 10-year Treasury note that you would purchase at this month’s Treasury auction (which is scheduled for Aug. 12). If interest rates stay where they are as this is written, that T-note would have a coupon rate of 0.56%. Where would this T-note be trading one year from now (August 2021) if the 10-year yield doubles, to 1.12%?
The answer: The T-Note would be trading for 95.2% of par in a year’s time ($952 per $1,000 face value). That’s a loss of principal of 4.8%. (This illustration doesn’t include accrued interest.)
No one likes a loss, of course. But, in my experience, some are surprised to learn that the scenario described here leads to this modest of a loss. They had imagined that a doubling of the 10-year yield over a year’s time would be far more devastating.
Another feature of bond pricing that surprises some investors: It makes a difference how quickly interest rates rise. Imagine that, instead of taking one year, it takes three years until rates double from current levels. In that event, the hypothetical T-note mentioned above would be trading at 96.2% of par -- or 3.8% below.
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The accompanying chart reflects any of a number of scenarios, both for different dates in the future and different possibilities for where the 10-year yield will be trading on those dates. The worst case scenario, of the 36 different ones plotted in the chart, would be for the 10-year yield to be at 3% in one year’s time. In that event, the T-note that you bought today would be worth just $809.
Even this loss, which could be quite damaging for many investors’ financial plans, needs to be put in perspective. The odds are low that the 10-year yield will rise more than five-fold in a year’s time, given how precarious the economy is. So in your risk-reward calculations, you are probably safe in giving little weight to that scenario.
Secondly, odds are decent that, whatever loss T-notes do incur in a sharply-rising rate environment, it will be less than what stocks lose over the same period. That’s relevant, because many investors currently are shifting a portion of their fixed-income portfolio allocation into equities. To that extent, you should consider any T-note losses in the context of what you would have lost had you invested in equities instead.
In any case, the risk of loss needs to be balanced against your potential gain should interest rates fall further. The German 10-year government bond, for example, currently trades at negative 0.56%. If the U.S. 10-year Treasury yield were to fall to that level in a year’s time, the T-note you buy today would then be worth $1,104 -- a gain of 10%. (This is also illustrated in the chart.)
This chart provides specific examples. But, ideally, you will become comfortable doing these calculations yourself. Excel and Google Sheets each provide in-built functions that do all the heavy lifting for you, so it’s not as daunting a challenge as it might otherwise seem. For both these programs, that function is “PV,” for present value. You can find many helpful videos online on how to use either of these program’s functions.