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If My Investment Strategy Hasn’t Changed, Then My Interest Rate Risk Hasn’t Changed—Right?

October 3, 2013

 

We often are asked “If I keep my investment strategy the same through various rate cycles, won’t my interest rate risk be the same?’’
The answer is no.
Let’s take a simple example of a 5-year bullet purchased in June of 2013 compared to a 5-year bullet purchased in June of 2007.
As of June 2013, a 5-year bullet would yield approximately 0.80%, while the average cost of funds for the industry was 0.59%.  This provides a margin of 0.21%.  A 5-year bullet purchased in June 2007 would yield approximately 5.40%, while the average cost of funds for the industry was 2.70%.  This provides a margin of 2.70%, going a lot further to covering the operating expense structure over the long run.
So it’s evident that the earnings potential is dramatically different, but what about the interest rate risk?
From an interest rate risk perspective, at first glance, there doesn’t appear to be much difference in the change in value between the June 2007 and June 2013 5-year bullets in a +300 environment. Please see below:

Question: How many years of earnings would it take to offset the potential risk of the 5-year bullet purchased in 2007 versus the 5-year bullet purchased in 2013?

Answer: For the bullet purchased in 2007, a little over 2 years (How do you figure?  Just take the loss/the yield:  -12%./5.4% = 2.2 Years).

For the bullet purchased in 2013, a little over 17 years (14%/0.80% = 17.5 years).

So yes, even if you have not changed your investment strategy, your interest rate risk and risk/return trade-offs have materially changed, making business decisions based on asset/liability management more important.

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