Should You Worry About Bond Mutual Funds if Interest Rates Rise?

Key Points

  • Both individual bonds and bond mutual funds will drop in value if interest rates rise.
  • Should this concern you if you're invested in bond funds?
  • We discuss how to stay focused on your investment objectives and manage interest-rate risk.

If interest rates rise, how will this impact your bond funds? A rising interest-rate climate causes bond prices to fall (all else being equal).

But don't worry, the news may not be as bad as it seems. Returns from bond funds come from two sources: interest payments (paid out as fund distributions) and changes in price. Higher rates can boost interest payments, and help buffer negative price returns. We’ll take a look at why this has been the case historically and offer suggestions so that you can select a bond fund that meets your needs.

Bond funds in a rising-rate environment

What happens to a bond in the short term when interest rates rise? Basic bond math tells us that prices will generally fall if interest rates rise. The longer the maturity, the more severe the price drop.

For individual bonds, this price volatility may not be much of an issue if you hold your bonds to maturity. Barring default, you'll receive a known principal amount back at maturity.

Bond funds, on the other hand, don't have a set maturity date. You may find that when you need to get your money back, you have to sell shares—and these shares may fetch a lower price than when you initially bought them in a rising-rate environment.

Bond fund returns have two sources: changes in price and interest payments

While the price of your bond fund might drop if interest rates rise, there’s another source of potential returns for your bond fund: interest payments.

The good news is that these interest payments have actually helped offset negative price returns over time. Take a look at the table below. It shows that interest payments for the Barclays U.S. Aggregate Bond Index have always been positive, and have helped to buffer negative price returns when they've occurred. In the past 15 years, price returns have been negative seven times, and in all but two of those years, the interest return helped to fully offset the negative price return.

Coupon returns have been positive and helped buffer negative price returns

Coupon returns have been positive and helped buffer negative price returns

Source: Barclays U.S. Aggregate Bond Index, as of 12/31/2013. Pay down returns, which are a component of the total returns, are not shown as a separate column.

It may come as a surprise that the returns from a "passive" portfolio of fixed income investments has come almost exclusively from returns on interest payments from individual bonds, reinvested and compounded over time. Furthermore, more than 90% of the total return since 1976 generated from a broadly diversified portfolio of U.S. investment-grade bonds has come from interest payments, not change in price.

In addition, rising interest rates often translate into higher interest payments over time. So although the price of a bond fund may drop in the immediate term due to rising rates, over time, higher rates could eventually help bond fund investors, in our view.

Income drives bond fund returns over time

Income drives bond fund returns over time

Source: Barclays. Returns shown are from monthly Barclays U.S. Aggregate Bond Index returns from January 1976 to December 2013. Total return equals income plus change in price with a reinvestment of interest payments. Past performance does not guarantee future results.

When could higher rates boost fund income returns enough to offset the price drop?

Now, you may ask, "How long might this take?" The illustration below shows the hypothetical "time to recovery," also known as the breakeven point, using some basic assumptions. Utilizing the illustration below as an example, if interest rates were to rise by 1% per year, it would take approximately 3.5 years to break even, and after six years, the fund would be up about 12%. Assuming a fund with a shorter time horizon, it would take a shorter amount of time to recover the loss due to rising interest rates. The point is that although the fund experienced a loss initially due to rising interest rates, over time, the fund's return actually turned positive even though interest rates were rising during this time period.

"Time to recovery" for sample intermediate-term fund

Time to recovery for sample intermediate-term fund

Source: Schwab Center for Financial Research. This assumes an average interest rate of 3.0%, an even 1% increase in rates each year for the first five years, an average duration of 4.5 years and reinvestment of interest income. It 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.

On the plus side, every day you hold a bond fund you earn a positive coupon return. And as time passes, this cumulative coupon continues to grow–assuming you do not take distributions. So, rather than starting from a 0% cumulative total return—as cited in our example—due to the passage of time and earning a coupon, you may already be starting with a positive total return. This will help to buffer some of the initial price decline.

Choosing bond funds by investment horizon and duration

When investing in a bond fund, the first step is to identify when you think you'll need to spend your initial investment—also known as your principal.

After making this determination, match your investments with your time horizon.

  • If you need your principal in one to four years, choose short-term bond funds.
  • If you don't need the money for four to 10 years, consider intermediate-term funds.
  • And go with longer-term funds only for money you won't need for 10 years or longer.

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.

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

Source: Schwab Center for Financial Research

Also, pay attention to the fund's duration. Duration is a measure of interest rate sensitivity, but it can also be thought of as a measure of how long it takes to recover your initial investment. Funds with shorter durations will typically be less sensitive to increases in interest rates and you’ll generally recover your initial investment sooner if interest rates rise as compared to funds with longer durations. However, funds with shorter durations typically have lower yields.

Keep in mind that we're not talking about when you might need to spend income. We are talking about when you’ll need to spend the initial investment. Ask yourself when you will need to cash out and realize any loss (or gain) from a bond fund investment. Over a longer time horizon, a fund should have time to recover any drop in bond prices with higher income if interest rates rise.

For fund ideas, use the Schwab Mutual Fund OneSource Select List®. Be sure to match the type of fund with your risk tolerance and time horizon.

I hope this enhanced your understanding of bond funds. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor's Feedback box.)

 

Next Steps

Talk to Us
To discuss how this article might affect your investment decisions:

  • Call Schwab anytime at 877-338-0192.
  • Talk to a Schwab Financial Consultant at your local branch.

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Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.