When Rates Rise, Time To Avoid Bond Funds?

When Rates Rise, Time To Avoid Bond Funds?

As interest rates continue to hover at historical lows, many people (including some investment advisors) express concerns about investing in fixed income mutual funds.  The issue – for those who are not familiar with bonds – is that when rates rise, bond prices fall, and vice-versa.  The fear is that bond funds, which hold numerous bonds, risk losing value whenever the Federal Reserve (Fed) increases the Federal Funds Rate.  And the Fed has already announced that the next rate increase could come as early as this month. The alternative is to purchase individual bonds. If an individual bond is held to maturity, the owner is guaranteed to receive the full value of the principal (unless the issuer goes bankrupt). Is holding individual bonds (or a bond ladder) in fact the best way to protect your fixed income investments from rising rates?

The answer is no.  Here’s why:

Recognize that there are two components to bond returns: capital gain or loss (i.e. changes in price), and the interest earned on the bond.  After a rate rise, if an individual bond is held to maturity, the bondholder will avoid the consequent price drop but will be giving up the higher income that he/she could have gotten by selling the bond and purchasing a higher-yielding bond.

Which has the greater impact on a bond’s return?  In 2011 Brandes Institute compared the returns from each of the two components for U.S. bonds over rolling 5-year and 20-year periods going back to 1928.  They found that across the average of all 5-year periods the interest returns represented almost 90% of the total bond returns. For the 20-year periods it was closer to 100%.  In other words, the impact of price declines for bonds held for more than five years over the last 85 years or so – which included one period of rising rates and two of declining rates – was miniscule compared to the interest generated by the bond investments.  So buying & selling (which is what funds do) would have provided better returns than simply buying and holding.

Another factor to consider is that bond prices tend to increase as they move closer to their maturity date in most “normal” upward-sloping yield curve environments.  Therefore after an interest rate rise (and consequent price drop), the price has farther to rise as the bond matures and therefore increases more rapidly for some period of time immediately afterwards.  Actively-managed bond fund managers understand this well and can time the sales of the older bonds to squeeze out additional returns while acquiring newer, longer-maturity bonds paying higher interest.  This process is known as “rolling down the curve” and is one of many things a fund manager can do to improve returns.  By contrast, if you hold bonds to maturity you lose the ability to take advantage of this and other techniques for generating additional returns.

What if an individual bond investor chose instead to create a bond ladder – the purchase over time of a series of bonds with overlapping maturities – to avoid remaining stuck with low-interest bonds after rates rise?  Unfortunately, in today’s low-yield environment, with inflation currently running at 1.9% and short-term treasuries yielding less than 1.7%, such an investor would be locking-in returns at below-inflation yields for at least the next few years (or even longer depending on the bonds maturities). The only way to generate above-inflation yields right now is by utilizing corporate or other higher-yielding types of bonds.  Unfortunately, that would involve increasing credit risk and reducing the return certainty that owning individual bonds was intended to provide in the first place.  (When taking on credit risk, bond funds diversify it across many holdings.)  In addition, purchases of bonds other than treasuries in small quantities incur significantly higher trading costs, further suppressing the returns for an individual bond purchaser.

In summary, I can find no evidence to suggest that owning individual bonds provides better returns as compared to owning actively-managed bond funds during rising rate environments. And if bond fund investors want to protect themselves from rate increases, there are numerous things they can do, such as choosing only funds with low durations and/or avoiding passively-managed bond funds or ETFs (which simply track some bond index and do not have the investment flexibility described above).

There’s really no need to fear rising interest rates or their impact on fixed income mutual funds.

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