by Gabriela Piranha
FINRA warned investors that an increase in interest rates may adversely affect bond funds that hold long-term bonds. FINRA highlighted the importance of a bond’s duration risk – the risk associated with a bond price’s sensitivity to a one percent change in interest rates. In particular, “the higher a bond’s duration, the greater its sensitivity to interest rate changes.” However, FINRA warned that a low duration does not mean that a bond or bond fund is risk-free.
Gerri Walsh, FINRA’s Vice President of Investor Education, warned that “with interest rates hovering near all-time lows, investors should make sure they know their duration numbers. Whether investors own individual bonds or bond funds, they need to understand that outstanding bonds with a low interest rate and high duration may experience significant price drops if interest rates rise.”
Investors should look at a bond fund’s Fact Sheet under Bond Holding Statistics to find the duration of their bond fund. Additionally, to determine an individual bond’s duration investors may refer to their investment adviser, the bond’s issuer, or other materials, such as prospectuses, issued by the issuer.
FINRA provided the following example: “a bond fund with a 10-year duration will decrease in value by 10 percent if interest rates rise one percent” and vice versa. However, it is important to note that the aforementioned assumes an exact inverse correlation between bond price and interest rate; however, such an assumption cannot be made with more complex instruments.
Accordingly, based on economists’ prediction that interest rates are likely to eventually rise, FINRA encourages investors to be cognizant of the duration risk associated with their bonds and bond funds.