1. It’s unlikely that interest rates will rise given the
current environment and the Fed’s position.
2. Nonetheless it is still possible that interest rates can
rise sooner than expected.
3. If/When interest rates do rise it is unlikely there will be
a huge YoY rise:
- Large rises in interest rates tend to happen in bunches and are preceded by smaller jumps
- Large rises happen with higher interest rates and inflation, we have low interest rates and low inflation
4. Even if I look at the worst data from all cases and try to
estimate the loss, the resulting portfolio capital loss isn’t one of
decimation.
- Current duration is 4.85, current interest rates are 1%: if rates move up 5% this equals a loss of roughly 23%.
- More likely bad scenario (still not likely) is interest rates rise 2.50%: holding the above constant equals a loss of roughly 11% (about the worst it would seem from the data), and doesn’t take into account likely credit spread tightening.
5. As a result, worrying about destroying capital because of
rising interest rates is probably a misplaced.
Still some losses are very possible and keeping duration within an
acceptable range given the current steep curve, low inflationary environment,
and low yields is prudent.
6. Lastly, anything is possible, so have
a plan in place if the trend reverses and rates move up quickly.
