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Investors, it's important to know your duration

The country's largest banks recently reported encouraging results for our economy. Citigroup, J.P. Morgan, Wells Fargo and Bank of America all reported lower trading revenue.

As a result of Dodd-Frank, the banks are finding it harder to trade with our money. They must keep higher capital reserves. Those regulations have been a burden on the Wall Street banks. Lower trading revenue was offset by growth in their consumer lending banking. That's good news for us main street folks. That means they are beginning to lend more for home purchases, business expansion and auto purchases.

These developments are encouraging for other reasons. The only sector in the S&P 500 stock index that has not turned positive since the great debacle of 2008/2009 is the financial sector. With interest rates at historically low levels, it is harder for the banks to work the spread. As the economy improves, there will be pressure for interest rates to rise.

Higher interest rates offer higher spreads that enable the banks to improve their profits. The spread is typically the difference between what the bank pays for deposits and the amount it charges for loans.

There are many ways to invest in the financial sector via individual stocks, mutual funds or unit trust. I prefer a low-cost exchange-traded fund such as the SPDR Select Sector XLF. It contains all of the major banks, has a dividend yield of approximately 2.5 percent and has an expense of only 14 basis points. Like any investment, please check with your financial adviser as this type of investment may not be appropriate for you.

About duration risk

While rising interest rates may help the financial sector, they create challenges with existing bonds.

That leads to what can be referred as the ticking time bomb inside today's bond market. It is called duration risk.

To understand duration, it is first important to understand how interest rates and bond prices are related. Interest rates and bond prices move in opposite directions. When interest rates rise, traditional bond prices fall.

For this discussion we will only be discussing traditional bonds. If you own a bond that is paying 4 percent and interest rates increase, that 4 percent yield does not look so attractive. It has lost some of its luster and, of course, value in the market.

Exactly how does duration work? The rule is that for every 1 percent increase or decrease in interest rates, a bond's price will change approximately 1 percent in the opposite direction.

For instance, if a bond has duration of 10 years and interest rates fall by 1 percent, that bond will increase in value by approximately 10 percent. Conversely, if interest rates rise by that same amount, the bonds value will fall by approximately 10 percent. If one is reaching for yield with long-term maturities up to 30 or more years, it is easy to see how devastating increasing interest rates can be to one's portfolio.

Duration is helpful because every individual bond and every bond (mutual fund) fund has duration. It is a useful tool that can be used to compare bonds and bond funds as you manage your portfolio.

While no one expects interest rates to jump immediately, there are some things that can be done to protect against high duration and rising interest rates.

First, learn what your duration is for your entire bond holdings. Your adviser can assist you with this. If you determine that your duration is too high, here are a few things to consider to reduce that condition.

If you invest in bonds via mutual funds, look for funds that invest in more medium- and shorter-term bonds. They will not be affected by increasing rates as much as longer maturity funds. But they will still be affected. I am not a big believer that fund managers will be able to buy higher yielding bonds as rates rise and keep the value of the funds stable. At the same time they are buying higher yielding bonds, they will also be experiencing client outflows as rates rise. It will be difficult for them to maintain a stable, much less increasing, share value.

Medium- or short-term unit investment trusts are another way to go. They do not typically trade any bonds once the portfolio is established, and the investor will not be competing with outflows such as with mutual funds.

Another approach is "bond swaps." Bond swaps mean selling bonds that have lost value and swapping them out for similar bonds that can be purchased for the same approximate price as the bond sold. There is a little more effort and cost in doing this, but it may allow an investor to hold longer duration bonds and thus higher paying interest rates while also protecting one's principal.

For investors who can afford to do so, the best approach is to buy individual, investment-grade bonds with a five- to six-year maturity. If rates continue to increase slowly, these bonds will hold their value best and at maturity one's principal is returned. When holding bonds to maturity, the duration is zero.

Investing in bonds with shorter maturities mean lower interest paid as compared to longer duration bonds. It may be difficult for many readers to do this and to maintain an income stream to meet their needs.

Don't let that ticking time bomb in your portfolio blow up on you. Learning your duration is the first step in defusing this risky situation.

Michael T. Doll, an investment adviser with the Longboat Key Financial Group, can be reached at 941-383-2300, ext. 6, or Michaeltdoll@longboatkeyfinancial.com.

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