“Interest rates must rise—it’s inevitable. And if they do, bond prices will fall.”
Whether you’re concerned about the first part of this statement or not, the second part is unquestionably true. A rising-interest-rate climate is not good for bond investments … at least in the short term.
Both individual bonds and bond funds share interest-rate risk—that is, the risk of locking up an investment at a given rate, only to see rates rise. At least with an individual bond, you can re-invest it at the higher, market rate once the bond matures. But the lack of a fixed maturity date on a bond fund increases concern for many bond fund investors.
Whether you’re invested in bond funds for income or as part of a diversified portfolio, what should you do (if anything) if interest rates start to climb? To address this question, we’ll look at the components of bond-fund returns and how different fund types might perform if rates rise. Then we’ll look at a strategy to help you choose bond funds wisely based on your investment horizon.
The components of bond-fund returns
For stock mutual funds, the primary source of investor returns is rising stock prices, translated into a rising net asset value (NAV) and fund share price. Dividends can be meaningful for some fund types, but are a secondary source of return for most.
Returns from bond funds, however, come from two sources: interest payments, paid out as fund dividends, and changes in price. Over time, interest payments typically contribute far more to returns than changes in price, at least for most bond funds.
When bond prices increase, the rising prices increase the NAV and add to the return of a bond fund, and when bond prices fall, NAV, and returns, decline. Over time, the ups have tended to be balanced out by declines, as shown in the chart below (using the Barclay’s U.S. Aggregate Bond Index as a proxy for performance in a diversified, investment-grade bond fund). This has been true even over a 30-year period where interest rates have been decreasing, widely acclaimed as a 30-year “bull market” for bonds.
Whatever happens to the value of bonds investments, however, income is always positive, and it’s been the more reliable part of bond fund returns over time. More than 90% of the total return since 1976 generated from a broadly balanced portfolio of US investment-grade Treasury, agency and corporate bonds has come from interest payments as opposed to change in price, as you can see in the table below.
Income drives bond fund returns over time
Returns shown are from monthly Barclays US Aggregate Bond Index returns from January 1976 to December 2012. Total return equals income plus change in price with a reinvestment of interest payments. Past performance does not guarantee future results.
While price returns varied over that time period depending on interest rates and economic cycle, rising periods tended to be counteracted by periods where prices decreased. Also, unlike stocks, bonds held individually, or in mutual funds, generally mature and ultimately pay off a par value at maturity—they don’t rise in price indefinitely. Over time, interest payments generate the majority of returns, especially as fund managers were able to reinvest interest payments and principal to accumulate and compound over time.
Bond funds in a rising-rate environment
But what happens in the shorter term when interest rates rise? Basic bond math tells us that prices will fall if interest rates rise. The longer the maturity, the more severe the drop.
However, this drop in price is not a “realized” loss unless you or the fund manager chooses to sell before maturity. Most bonds continue to generate interest payments, and their prices move back toward par at maturity, whether held by you as an individual or in a bond fund.
To help gauge the interest-rate risk in your portfolio, follow these simple steps:
- Find a fund’s average maturity—on schwab.com, enter a fund’s ticker on the Mutual Funds tab under Research, then click on the Portfolio tab. You’ll find the average maturity in the lower-left corner, in the Portfolio Overview section.
- The higher the average maturity, the more impact you’ll see if rates change.
- Today, the average intermediate-term bond fund has an average maturity of seven years (and a duration, for more advanced investors, of 4.5.)
Duration is a measure of interest rate risk. As a rule of thumb, a fund with an average duration of 4.5 will rise 4.5% in value if rates fall 1% and fall 4.5% if rates rise 1%. If they rise 2%, the drop will be roughly 9%, and so on (all else being equal).
After the short-term hit of a change in price, a rising-rate environment will eventually help bond fund investors, in our view. As bonds in the fund mature, the fund manager is able to re-invest principal at higher yields as rates rise. These higher rates boost fund income returns, eventually offsetting the drop in price.
The question is, “How long might this take?” If you have some sense of the answer to this question, you can focus on a question you can control: “How long is your investment horizon?”
Here’s a hypothetical illustration of “time to recovery,” using some very basic assumptions:
“Time to recovery” for a sample intermediate-term fund
Assumes starting average interest rate of 3.0%, an even 1% increase in rates each year for the first five years, average duration of 4.5 years and reinvestment of interest income. Shows cumulative return, not annualized return or dividend yield. Note: This is meant as an illustration, and won’t represent actual performance for any specific mutual fund. Actual performance will depend on fund management, as well as market conditions.
If you won’t need your principal and want income during this holding period, you’ll benefit from the higher yields from longer-duration (maturity) funds even if the NAV of the fund falls and recovers over time. (However, you won’t benefit from the compounding of reinvested interest/dividends, as shown in the example above). Just don’t forget your time horizon and risk tolerance.
Choosing bond funds by duration and your investment horizon
Professional fixed income managers, as well as pension fund and other institutional investors, often use a concept called “immunization” to match their investment horizon to interest risk, no matter the interest-rate environment.
First, decide when you’ll need to spend your initial investment—that is, your principal. Might you need it tomorrow? Within the next couple of years? Four years or more, or some longer time horizon?
You’ll want to match your fund investments with your time horizons. For principal you might need over the next one to four years, choose short-term bond funds. Money you don’t need right away, consider intermediate-term funds. Save longer-term funds only for money you won’t be needing for a long time (or avoid them altogether if you’d prefer to avoid the volatility if rates rise).
We see limited value and higher risks in long-term funds today compared to intermediate-term funds. The benefits of a slightly higher rate aren’t well-balanced with the increased interest-rate risk, in our view, for funds with average maturities much greater than 10 years. An exception might be if you’re focused on income and income alone and won’t need to sell, or if you believe that interest rates will fall. While we believe rates could stay lower longer than many investors expect, they will rise eventually.
Match the average maturity1 of a fund with your investment horizon. Over time, this will match interest-rate risk with higher returns over this targeted investment horizon.
Choose Morningstar Bond-Fund Categories Based on Time Horizon
|Short-term bond funds||Intermediate-term bond funds||Long-term bond funds|
|Need principal in one to four years||Need principal in four to 10 years||Need principal in 10 or more years|
|Short government||Intermediate government||Long government|
|Short-term bond||Intermediate-term bond||Long-term bond|
|Muni national short||Muni national intermediate||Muni national bond|
Keep in mind that we’re not talking about when you might need to spend income, if you’re an income investor, as opposed to one who doesn’t need income today, but reinvests bond fund dividends to maximize total long-term returns over time. You can choose to do either.
The question is principal. When might you need to sell, to cash out principal and realize any loss (or gain) from a bond fund investment? Over a longer time horizon, a fund with a similar horizon should have time to recover any drop in bond prices with higher income if interest rates do rise.
Other issues to consider
In the current low-interest-rate environment, there are a couple of other stumbling blocks to be aware of, including:
- Leveraged funds. This includes many closed-end bond funds, many of which borrow money in the short-term market and then use that borrowed money to buy longer-term bonds with higher yields, adding leverage and boosting yield from the funds. This can work great when short-term interest rates are low, but it makes leveraged closed-end funds more susceptible to a more rapid decline in prices when rates rise.
- Unconstrained funds. Many new types of “unconstrained” or alternative strategy bond funds have been launched over the past few years. These funds use derivatives and other strategies to change duration and interest-rate risk based on market conditions. Some may even achieve a negative duration2 through the use of derivatives. This is not a recommendation to avoid them—just to understand what you own.
- Floating-rate funds. Many commentators have pointed to floating-rate as well as bank-loan funds—mutual funds that hold bonds whose rates adjust with market rates—as a solution to manage interest-rate risk. These may make sense for some investors for a more opportunistic portion of their bond-fund allocation, but they may not provide the degree of protection in a rising-rate environment that investors may believe. Floating-rate funds are not a cure-all to interest-rate risk, and may include securities with higher credit risk or with interest-rate caps that may not increase in lock-step with the market.