Rough Waters Ahead for Bond Funds?

It's been a great run for bonds. But the future looks less certain.

Roger Wohlner

As you’re probably aware the Federal Reserve last week has indicated that they will continue their efforts to keep interest rates low. At some point, however, rates are likely to rise (that’s not a prediction of when, or how quickly). Rising interest rates are the enemy of fixed income investors, as interest rates and bond prices move inversely with each other.

The total return of a bond fund is a combination of:

  • The price changes of the underlying holdings, gains or losses when those holding are sold, and the interest received from the individual holdings.
  • Bond prices are impacted by a number of factors including:
    • The direction of interest rates.
    • Rising inflation, which is the enemy of most bond holders in that the interest rate payments they receive are fixed and lose purchasing power during periods of inflation.
    • The perceived ability of the issuer to make good on their promise to make periodic interest payments and to redeem the bond at maturity.
    • The time to maturity of the underlying bonds in the fund. The longer the time to maturity, the more sensitive the bonds will be changes in the interest rate.
    • In the case of funds that hold foreign bonds, the relative value of the currency of the issuing country can impact the value of the fund if the fund does not hedge various foreign currencies represented in the fund versus the dollar.
    • Here are some considerations for investors in bond mutual funds and ETFs going forward:

      Bond funds do not mature. If you buy a bond that matures in September 2022, upon maturity you will receive the value of the bond (generally $1,000) and any interest payments that are made between now July and 2022. Neither of these payments will be impacted by the direction of interest rates. Other factors such as call provisions, a default by the bond issuer, or selling the bond prior to maturity could impact your return on the bond. On the other hand, bond fund portfolios are perpetual in nature. Some of the bonds in the portfolio will mature, others will be sold by the manager for various reasons, and others will be added to the portfolio. This fluidity makes bond funds continually sensitive to interest rate gyrations. The return on any bond fund will be a combination of interest payments received and the gains and losses of the underlying bonds in the portfolio.

      A vintage financial bond.

      Active versus passive. Rightly so, many advisors and financial journalists tout the benefits of investing in low-cost index funds and ETFs. Low-cost index funds such as the Vanguard Total Bond Market Index have been very solid performers. However, bond index funds may be constrained when interest rates rise; where as an active manager might have more leeway within the fund’s investment policy to make trades to mitigate the impact of rising interest rates.

      Duration is a quick way to gauge the impact of rising rates on a fund. Duration is a time value of money calculation that takes into account the cash flows of the bond and the time until maturity. In plain English, duration is a quick way to gauge the impact of a 1 percent change (rise or fall) in interest rates on your fund. For example if your fund has a duration of five years this means that a 1 percent rise in interest rates will likely result in a 5 percent decline in the underlying value of bonds held in the fund. This number can be found via Morningstar and certainly in other places.

      Bond funds and ETFs offer professional management and many other advantages. However, going forward it is imperative that you understand both the benefits provided by your bond fund investments and the risks inherent in the fund going forward. Fixed income investors have had a strong wind at their back so to speak with the continual decline in interest rates over this period. I suspect the next 10 years will look very different for holders of bond funds and ETFs than the previous decade.

      Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. Read more about Roger here.