Since the start of the year, the benchmark 10-year Treasury has risen about 20 basis points (1 basis point equals 0.01%) to 1.15% at this time of writing. The yield is still relatively low, but it is at the highest it’s been since last March.
The rapid rise in yield has fuelled concerns amongst bond investors. Typically when interest rates – and by extension, bond yields – rise, bond prices fall.
Here’s an example that illustrates this concept.
Let’s say you purchase a bond for $1,000 that matures in two years and pays a coupon of 2%. This means you will receive annual interest of $20, plus your original $1,000 investment back when the bond matures.
When interest rates go up, new bonds will be issued with the higher interest rate of say 3%. The “old” bond that pays 2% becomes less attractive to investors and they will not pay the “original” price of $1,000 for it. When this happens, the bond price falls and we say that the bond is trading at a discount.
Understanding bond price fluctuations
Depending on the interest rate environment, bond prices can change. While the thought of your bond portfolio fluctuating in value can seem unsettling, changing prices don’t affect you if you plan to keep your bonds to maturity.
That’s because if you hold bonds to maturity, you will receive your principal in full – assuming there has not been a default. So no matter how interest rates and bond prices change, you’ll ultimately receive your original investment in full at the maturity of your bond.
However, if you need to sell your bonds before maturity, rising interest rates could pose a problem as you may need to sell your bond for less than your purchase price.
The advantage of shorter term bonds
One way to mitigate the impact of rising interest rates would be to invest in shorter term bonds. Bonds with longer maturities tend to be more heavily impacted by changing interest rates. If you own a 10-year bond that pays a coupon of 4%, would you be willing to hold the bond for 10 years when new bonds are being issued at 7% interest? This is why the longer the maturity, the greater the interest rate risk.
For investors who think that interest rates are going to rise in the near-term, shorter term bonds also allow them to take advantage of market opportunities faster. At maturity, they can reinvest their principal and move into bonds with higher interest rates.
Rising interest rates and Syfe Cash+
With the rapid rise in 10-year Treasury yields, some investors are understandably concerned about what that might mean for Syfe Cash+.
Syfe Cash+ holds three Lion Global bond funds of differing maturities. In general, the bonds within the Money Market Fund mature every 3+ months. The bonds within the Enhanced Liquidity Fund do so every 9 months, and the bonds within the Short Duration Bond Fund mature every 2 years. Taken together, the weighted duration of Syfe Cash+ is 1.12 years.
If interest rates rise, you can rest easy knowing that the majority of your underlying bond holdings will mature in the next 6 to 12 months. The fund manager Lion Global will then re-deploy your funds into higher-yielding bonds.
For your short duration bond component, you can simply hold it to maturity to negate any price impact due to interest rate spikes. Given the relatively short duration of the bond (1.98 years), we do not foresee any price impact to be significant as well.
What if interest rates fall?
Interest rates falling could be another possibility. At this juncture however, interest rates are already at historic lows and they are unlikely to go even lower. The SGD 12-month SIBOR is at 0.81% as at January 2021, down from nearly 2% just one year ago. Likewise, the MAS bank 12-month fixed deposit rate and Singapore Savings Bonds rate had dropped to around 0.24% in December last year. We are close to the lowest interest rate levels in Singapore’s history, and it seems unlikely that interest rates will continue to fall further.
Despite the market chatter, we also don’t expect interest rates to rise significantly over the next few years. Following the Federal Open Market Committee (FOMC) meeting last December, the majority of FOMC members see no rise in rates through 2023. Secondly, the coronavirus pandemic is far from over. Central banks worldwide are likely to continue their stimulus programmes to prop up their economies. The takeaway from this is that the Federal Reserve’s zero-rate policy is going nowhere soon.
As such, we expect the Syfe Cash+ projected return of 1.75% p.a. to remain range-bound for the foreseeable future.