When investing in bonds in a rising rate environment, how can you decide whether to buy individual bonds or bond mutual funds? When interest rates rise, the prices of both bonds and bond funds are likely to fall. So, is one substantially better than the other?
In some investors’ eyes, bond funds get a bad rap. When you hold an individual bond to maturity, you’re spared the impact of price fluctuations, but bond funds—being baskets of bonds of varying maturities—don’t seem to offer the same safety of principal.
Nonetheless, there are a couple of reasons that owning bond funds might be preferable, even in today’s climate.
Comparing bonds to bond funds
First, let’s review how individual bonds and bond mutual funds work.
Bonds typically make twice-yearly coupon payments. If you hold a bond to its maturity date, you receive a principal amount, known as the face value. In the meantime, the price of the bond can rise or fall.
If you decide to sell the bond prior to the maturity date, that’s done at the market price, which could be lower than the price you originally paid for it. (And if the issuer of the bond defaults, you won’t collect all the coupon payments and you may not even recover the face value.)
If you plan to hold a bond to maturity, however, its price volatility may not concern you. But that buy-and-hold certainty comes with an opportunity cost: If rates rise while you’re holding the bond, you could miss out on the higher coupons offered by newer bonds on the market.
Bond mutual funds, by contrast, include numerous bonds, which have a variety of maturity dates and income payments. Unlike individual bonds, most bond funds don’t have a set maturity date, since their bonds are constantly maturing, being bought and sold. Instead, most bond funds will hold bonds of similar maturities (short-term, intermediate or long-term) or types (government, high-yield, inflation-protected, etc.).
While it may seem logical to look at their prices, bond fund returns over time are driven more by coupon payments than by changing prices. Those coupon payments are paid out to the investor in the form of monthly distributions. Bond fund managers can react to changing interest rates by buying or selling bonds to try to maximize coupon income. When interest rates rise, income-oriented investors can benefit, as the monthly payments from their bond funds can climb—and they may continue to collect higher income if rates increase further.
Still, keep in mind that despite the income offset and historically positive total returns, bond funds offer less certainty about whether you’ll be able to recover your principal at a specific time than individual bonds do, particularly in a rising rate environment.
The benefits of bond fund income distributions
Over time a bond fund’s income payments often help to compensate for price fluctuations. Historically, income payments for the Barclays U.S. Aggregate Bond Index have been consistently positive, even though price returns have been negative in seven of the last 15 years.
In fact, in all but two of those years, income payments offset negative price returns and resulted in positive total returns for the index, as you can see in the graph below. Since 1976, more than 90% of the total return for a broadly diversified portfolio of U.S. investment-grade bonds has come from income payments rather than price.
There are two good reasons for this: bond sales and coupon reinvestment. One way managers can increase a fund’s coupon income is to sell lower-coupon bonds and buy bonds with higher coupons when rates rise. Another way is to reinvest the income payments from individual bonds in higher-yielding bonds if rates rise—a process facilitated by the fact that investors can choose to have their monthly distributions reinvested the fund to buy new shares.
So while the price of a bond fund may drop in the short term because of rising rates, the return to the investor may increase over a longer period because of the rising income payments. You might see a setback in price, but typically this is temporary, and distributions offset the loss over time.
The amount of time it will take for a bond fund to reach the breakeven point—when it fully recovers any drop in price—depends on a number of factors, including the terms of the bonds in the fund and the speed with which interest rates rise. The funds category—short, intermediate or long—or its duration, which measures the average payback speed of bonds held in the funds, is a good place to start to determine a hypothetical breakeven. Short-term funds, all else being equal, tend to have shorter durations, meaning they are less sensitive to changing interest rates. Intermediate- or long-term funds have longer durations and, generally, take longer to benefit from rising rates.
Assuming you reinvest fund distributions and can hold the investment for a period of years, the income payments in any of these fund categories plays a large role in returns.
Which bond fund is right for you?
When choosing a bond fund, the first thing to consider is how long you plan to hold the investment. If your horizon is one to four years, short-term bond funds could be for you. They generally have lower income, but less volatility in price. For a four- to 10-year horizon, consider intermediate-term funds. If you won’t need the money for 10 years or more, long-term funds might make sense.
These days, with interest rates seemingly poised to rise, intermediate-term bond funds may capture many of the benefits of long-term funds with less interest rate risk. While Federal Reserve guidance suggests interest rates are likely to stay relatively low in the immediate future, eventually they are likely to rise, making long-term bond funds less attractive, in our view, than short- and intermediate-term bonds or funds.
Another good way to help determine whether a specific bond fund is right for your portfolio is by matching its duration to your tolerance for risk.
Funds with shorter durations have lower yields, but should recover more quickly from interest rate hikes. The longer the duration, the more volatile the bond fund’s price will be when interest rates fluctuate.