Bond Funds and Rising Interest Rates
After years of keeping the benchmark federal funds rate at historic lows, the Federal Reserve has begun to raise it gradually. This is not necessarily a bad trend; near-zero rates were an emergency measure, and gradual increases reflect greater confidence in the U.S. economy. However, rising rates tend to reduce the value of existing bonds because investors typically prefer to buy newer bonds paying higher interest.
Bond funds — mutual funds and exchange-traded funds (ETFs) composed mostly of bonds and other debt instruments — are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds. Thus, falling bond prices due to rising rates can adversely affect a bond fund’s performance.
Even so, there are good reasons to own bond funds during almost any market cycle, including the potential for income and stability to help balance more volatile stock funds and other equity holdings (see chart). Here are some ideas that may help you evaluate bond funds you already own or might consider adding to your portfolio.
Maturity and Duration
In general, longer-term bonds are more sensitive to rising rates, so funds that hold short- or intermediate-term bonds may be more stable as rates increase. Bond funds do not have set maturity dates, because they typically hold bonds with varying maturities, and they can buy and sell bonds before they mature. So you might consider another measure called duration, which takes into account the maturity dates of the underlying bonds, the value of future interest payments, and several other data points. The longer the duration, the more sensitive a fund is to changes in interest rates. You can usually find duration with other information about a bond fund.
To estimate the impact of a rate change, multiply a fund’s duration by the expected percentage change in interest rates. For example, if interest rates rise by 1%, a bond fund with a three-year duration might be expected to lose roughly 3% in value; one with a seven-year duration might fall by 7%.1 Although helpful as a general guideline, duration is best used when comparing funds with similar types of underlying bonds.
Other Factors to Consider
A fund’s sensitivity to interest rates is only one aspect of its value — fund performance can be driven by a variety of dynamics in the market and the broader economy. Moreover, as underlying bonds mature and are replaced by higher-yielding bonds within a rising interest rate environment, the fund’s yield and/or share value could potentially increase over the long term. Even in the short term, interest paid by the fund could help moderate any losses in share value.
It’s also important to remember that fund managers, who typically have some latitude, might respond differently if falling bond prices adversely affect a fund’s performance. Some might try to preserve the fund’s asset value at the expense of its yield by reducing interest payments. Others might emphasize preserving a fund’s yield at the expense of its asset value by investing in bonds of longer duration or lower credit quality that pay higher interest but carry greater risk. Information on a fund’s management, objectives, and flexibility in meeting those objectives is spelled out in the prospectus and also may be available with other fund information online.
The return and principal value of mutual fund and ETF shares fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Supply and demand for ETF shares may cause them to trade at a premium or a discount relative to the value of the underlying shares.
Mutual funds and ETFs are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1) Investment Company Institute, 2016