Can Bond Funds Make Sense When Interest Rates Rise?

Key Points

  • Although the value of most bonds and bond funds fall when interest rates increase, not all bond funds react the same way.
  • A look at how various bond fund categories performed in prior rate-hike cycles can help your fixed income strategy.
  • Short-term bond funds have performed better than intermediate-term, long-term or multisector funds during the past three rate-tightening cycles.

Rising interest rates can pose a challenge for bond investors. All else being equal, when rates rise, bond prices fall (and vice versa). That means a portfolio of bonds or bond funds could see some price swings when interest rates start to move.

But keep these swings in perspective, and keep concerns about rising rates in check if you can. Even though we’ve seen a spike in interest rates in the aftermath of the U.S. presidential election, and markets believe the Federal Reserve may raise short-term rates again in December 2016 or early 2017, the fear about the impact on bond funds—based on data from past rate-hike cycles—may be overstated.

We looked at how major Morningstar bond fund categories performed in the last three major rising-rate cycles, and how they’ve performed since the Fed rate increase in December 2015 (which was the first Fed hike since 2006).

Here’s what we found:

  • In the past three cycles, the earliest part of the rate-hike cycle, including the six months prior to the first hike, was the most volatile. The short-term bond category was the least volatile.
     
  • Short-term bond funds also were the only major category that had positive total returns in each of the rate-hike cycles.
     
  • Over time, the intermediate-term, long-term and multi-sector bond categories generally recovered and delivered positive returns, due the gradual impact of reinvesting in higher-yielding bonds, even as rates rose.

While no cycle is the same, we believe some important takeaways for investors are:

  • Match your investments to your time horizon. This includes your choice of bond funds.
     
  • Understand that the impact on bond funds may be felt prior to the Fed raising rates, and downside risk historically has been manageable.
     
  • Over time, bond funds may benefit from higher bond coupons, which are distributed to bond fund owners and reinvested to deliver potentially positive returns over time.

Bond funds and interest rates

Bond funds are professionally managed, diversified baskets of bonds with varying maturity dates and yields. Unlike individual bonds, bond funds typically don't have a set maturity date because they often buy and sell bonds before they mature, and they have no obligation to return your principal. Most funds make payments on a monthly basis (individual bonds generally make semiannual payments).

When interest rates rise, bond fund prices will likely dip, reflecting the drop in the fund’s underlying bond holdings. That could also affect the monthly income payments. However, a fund manager can react to rising rates by buying and selling bonds to try to maximize coupon income. For instance, a manager may sell lower-coupon bonds and use the proceeds to buy bonds with higher coupons, or may reinvest the income payments from individual bonds in higher-yielding bonds. Over time, that can actually boost the income you earn from a bond fund, meaning you can potentially recover from losses through increased returns.

Bond returns are generally driven more by income than by rising and falling prices over time. So when you see a negative cumulative return, that's typically telling you that even after income payments were accounted for, a drop in the bond fund's price dragged returns below zero.

A look at the current—and past three—rate cycles

Since 1990, the Fed has raised interest rates during four periods, including the period starting in December 2015:

  • February 1994 to February 1995
     
  • June 1999 to May 2000
     
  • June 2004 to June 2006
     
  • December 2015 to the present

The table below shows the four cycles and total return from four broad categories of bond mutual funds: short-term, intermediate-term, long-term and multisector bond funds.

The first three categories reflect the different average durations of the funds’ underlying bond holdings. A bond fund's duration acts as a gauge of its sensitivity to interest rate changes. Short-duration bond funds tend to be less sensitive to interest rate changes than longer-term ones, because investors recover their initial investment more quickly.

Multisector bond funds often seek to increase income by adding bonds with higher credit risk, including international and sub-investment grade bonds.

Prior rising rate cycles: Cumulative return

Rising Rate Cycle

Months

Fed Funds Rate

Short-Term Bond

Intermediate-Term Bond

Long-Term Bond

Multisector Bond

12/15 - present

10

0.0% - ?

2.1%

5.3%

12.5%

6.3%

6/04–6/06

25

1.25% - 5.25%

4.0%

5.6%

7.7%

12.4%

6/99–5/00

12

5.0% - 6.5%

3.1%

0.8%

-0.6%

0.5%

2/94–2/95

13

3.25% - 6.0%

1.1%

-1.7%

-3.6%

-4.0%

Source: Morningstar Direct, as of 10/31/2016. Past performance is no guarantee of future results. The categories reflect average total return, from reinvested dividends and change in net asset value, from mutual funds in each category, not a single fund, for the period.

Although bond fund investors may have experienced some losses related to interest rate risk in the last three tightening cycles, the immediate impact on bond funds was actually less than you might expect. The variation in performance was highest in the two categories we see as having higher interest-rate risk and volatility: long-term and multisector bond funds. 

Shorter-duration funds were most consistent

The charts below show cumulative total return over each cycle, starting six months before the first rate hike and ending 12 months after the last rate increase. The dotted line shows the date of the last Fed rate hike in each cycle.

2015 – Present: Rates rising from 0.0%

Source: Morningstar Direct, as of 10/31/2016. Cumulative total return by Morningstar bond fund category: short-term, intermediate-term, long-term and multisector. The cumulative total return includes automatic reinvestment of monthly distributions, net of fees.

2004–2006: Rates rose from 1.25% to 5.25% in 25 months

Source: Morningstar Direct, as of 10/31/2016. Cumulative total return by Morningstar bond fund category: short-term, intermediate-term, long-term and multisector. The cumulative total return includes automatic reinvestment of monthly distributions, net of fees.

1999–2000: Rates rose from 5.0% to 6.5% in 12 months

Source: Morningstar Direct, as of 10/31/2016. Cumulative total return by Morningstar bond fund category: short-term, intermediate-term, long-term and multisector. The cumulative total return includes automatic reinvestment of monthly distributions, net of fees.

1994–1995: Rates rose from 3.25% to 6.0% in 13 months

Source: Morningstar Direct, as of 10/31/2016. Cumulative total return by Morningstar bond fund category: short-term, intermediate-term, long-term and multisector. The cumulative total return includes automatic reinvestment of monthly distributions, net of fees.

In the past three cycles, the six months just prior to and few months just after the first rate hikes were the most volatile. Markets, after all, are forward looking. They often try to anticipate future moves in fundamentals—for example, interest rates—in advance. After the initial rate hikes, prices stabilized or recovered, and income payments gradually helped returns rise.

The short-term bond fund category was the only fund category we examined that delivered positive returns in each of the past three cycles. You can see that the share prices of short-duration funds, also known as their net asset value, dipped near the beginning of each of the cycles, but then regained their ground over time. 

The intermediate-term bond fund category also saw positive returns due to higher income payments as rates rose, but the income gains weren't enough to offset falling prices during the year-long tightening cycle from 1994 to 1995. That may be due to the comparatively steep rise in rates over that period, when the federal funds rate increased by 2.75 percentage points in 12 months. By comparison, over the 11-month tightening period from 1999 to 2000, the federal funds rate rose just 1.5 percentage points, and intermediate-term funds as a category delivered a positive return.

We expect "low and slow" rate increases in this cycle

How will the current cycle compare to prior cycles? The first thing to note is how clearly the Fed has telegraphed its intention to raise rates. We’ve already seen an increase in intermediate- and longer-term rates in advance of the expected hikes.

Another difference is that we expect the Fed to tighten short-term interest rates more slowly in this cycle than in the previous ones, which could result in less volatility for each of the bond fund categories mentioned above. That said, rates across the yield curve have already risen sharply, especially in the wake of the recent presidential election.

The so-called taper tantrum in 2013 offers an example of what can happen when markets jump before any rate increases actually take place. Short-term rates didn't change in 2013, but investors feared they soon would, so they bid up long-term rates. We may be seeing a similar effect now. Rates on 10-year Treasuries have risen from 1.58% to 2.26% in the last three months.  The table below also shows performance of each fund category in advance of the rate hike in December 2015 and over the last three months.
 

Anticipation: How tightening expectations affected bond fund returns

Recent Events

Months

Fed Funds Rate

Short-Term Bond

Intermediate-Term Bond

Long-Term Bond

Multisector Bond

8/16–10/16

3

0.25%

0.2%

-0.5%

-3.7%

0.9%

6/15–11/15

6

0%

-0.4%

-0.8%

-1.4%

-2.6%

5/13–12/13 (Taper Tantrum)

8

0%

-0.2%

-2.8%

-6.4%

-0.8%

Source: Morningstar Direct, as of 10/31/2016. The cumulative total return includes automatic reinvestment of monthly distributions net of fees. Past performance is no guarantee of future results.

A major change from the expected path, either in pace or magnitude of interest rate changes, would be a risk to fund performance. But it’s worth noting that this is a risk for markets overall, including equities, not just bonds or bond funds.

What to do now?

If you need to sell bond fund shares when prices are at their most volatile, you could be in for a loss. But the volatility that can follow a rate hike will likely be temporary, in our view.

If you’re buying a fund or reviewing your holdings in anticipation of a rate-hike cycle, it helps to make sure a given fund aligns with your risk tolerance and time horizon. Schwab has online tools that can help you research individual funds, including Schwab’s Mutual Fund OneSource Select List®, a pre-screened list of no-load, no-transaction-fee mutual funds. Schwab clients can access additional research tools at schwab.com/funds.

 

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call a bond specialist at Schwab anytime at 877-908-1072.
-          Talk to a Schwab Financial Consultant at your local branch.

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