How Are Bond Mutual Funds Impacted by Interest Rates and Bond Prices?

By Modern Wealth Management

June 1, 2022

How Are Bond Mutual Funds Impacted by Interest Rates and Bond Prices?

Key Points – How Are Bond Mutual Funds Impacted by Interest Rates and Bond Prices?

  • Bond Mutual Funds Are All About Duration
  • Going Back to the Teeter-Totter Example to Explain the Relationship Between Bonds and Interest Rates
  • Understanding What You Own in Your Portfolio
  • Remember, All Bonds Aren’t Created Equal
  • 8 Minutes to Read

Do Bonds Still Fit in Your Portfolio in a Rising Interest Rate Environment?

As our advisors have been meeting with clients and prospective clients in recent months, the bond market has no doubt been a hot topic of discussion, as the traditional bond market continues to crumble. When the “safe” part of the market loses money, it’s only natural to ask the question, “Why should I stay in bonds?” It’s a good question. The effect of interest rates and bond prices is critical to understanding what’s happening. It’s also important to remember that not all bonds are created equal. Remember, the bond market is much bigger than the stock market, and there are a ton of different bonds and alternative bonds to consider.

Most people own bonds in the form of a mutual fund or ETF. The fund manager buys and sells the bonds in the fund as they see fit or as allowed or required by the funds particular investment policy. The fund manager may or may not make changes in response to the current market environment depending on their policy. Since the fund manager is the one making decisions on what bonds to hold or sell, we need to know how much risk we’re taking in that fund. The risk can be measured by several factors, such as credit quality, ratings, and duration.

We’re specifically going to focus on the importance of duration to help answer that question. We’ll use some real bond funds to illustrate what it can tell us. Though we mention specific funds, we’re simply highlighting them to help you understand the principal rather than making recommendations. Please talk to your investment or tax professional before making any financial decisions.

Defining Duration

BlackRock defines bond duration as “a way of measuring how much bond prices are likely to change if and when interest rates move. For every 1% increase or decrease in interest rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration.”

What that means is if you had a duration of five years and interest rates move up by 1%, your bottom line is likely to decline by 5%. If your duration is 10 years, it would be a 10% decline.

Going Back to the Teeter-Totter Example

The easiest way to think about it is to reference the teeter-totter example that Dean Barber has recently shared on America’s Wealth Management Show and in our Modern Wealth Management Educational Series webinar, How Bonds Fit into Financial Plan.

Bond prices move inversely to interest rates. And the farther you are out on the end of the teeter-totter (duration), the more movement you get in the price of the bond. When you look at a bond fun, you can see average duration of the bonds in the fund. The shorter the duration, the closer they are to the middle of the teeter-totter, which means they don’t move around as much.

Let’s start by looking at the American Funds Bond Fund of America, which is a general bond fund. It’s going own a little bit of everything, kind of like the bond aggregate AGG, which is an ETF. So, let’s compare those two. Bond mutual funds can own many different types of bonds, and that represents the diversification of the fund. Diversification is generally important, even in the bond world. But duration is just as, if not more, important.

Believe It or Not, But You Can Lose Money in a Government Bond

For example, the American Funds Bond Fund of America has a duration of 6.89. Meanwhile, the duration of the bond aggregate AGG is 6.78 years. In the year-to-date period that this article was written, the 10-year treasury yield increased by 1.4%. If you multiply the 6.89 and 6.78, respectively, by 1.4%, that should equal your year-to-date loss. So, 6.89 multiplied by 1.4% equals a 9.65% loss. That’s exactly where the bond aggregate and Bond Fund of America set today.

“You can really start to see this when you compare it to a 20-year treasury. The 20-year treasury so far this year is -20%,” Dean said. “While interest rates were falling last year, the 20-year treasury looked really good. But now interest rates are rising, so the 20-year treasury is going down.”

It’s difficult for most people to believe that you can lose money in a government bond, but it’s true. We generally buy bonds for income, not necessarily capital appreciation. When you own individual bonds and hold them to maturity, you get their par value back in a lump sum. That means that the price fluctuations along the way don’t matter to you.

How Individual Bonds Work

Bonds are essentially loans to a business or a municipality that pay a coupon (interest payment) up until maturity, at which point you get the par value of your bond back in a lump sum. Every bond is issued at $100 par value. If you buy it at issue, you’ll pay par value for the bond. However, if you buy the bond after issue, you’ll either buy at a premium or discount to par value. This affects your yield to maturity (YTM) or how much income you’ll receive over the period you own the bond.

For example, let’s say a bond is paying 5% and matures in 2030. If you buy it for $110 today, you are buying it at a premium. So, even though it’s paying a 5% coupon, your yield would be slightly under 4%. And, when it matures, you’ll only receive $100 back even though you paid $110. And it works just the opposite if you buy at a discount. Your yield is higher than the coupon, and you get more money back than you paid for the bond at maturity.

When Bond Funds Can Pose a Problem

All individual bonds work that way, and all bond funds own a whole bunch of individual bonds. The problem is that the individual investor has no control over whether any of the individuals bond are going to be held to maturity. You’re basically investing into a blind pool.

If you’re in a rising interest rate environment, which we are, a bond mutual fund can be a less than safe place to be based on the types of bonds it holds and their average maturity. If the fund holds long dated, lower credit quality bonds, it is probably going to get beat up badly. You’d like to know that before you purchased the bond, right?

That is why understanding the duration of your bond fund or ETF is so important. Using the duration to figure what your loss potential is with each 1% increase in interest rates allows you to know in advance how much drawdown you might experience based on how much higher you think rates are going to go.

Remember, All Bonds Aren’t Created Equal

An example of that can be illustrated in the Deer Park Total Return Credit Fund. It owns bonds as well, but they’re a different type. The fund consists of deeply discounted mortgage-backed securities and asset-backed securities that have high cash flow and relatively short duration. This fund currently has a 5.2% dividend yield. And while it’s negative on the year, it’s only down about half of what the AGG is. You need to think about the fixed income portion of your portfolio differently in this rising interest rate environment and seek alternative strategies to traditional bonds to fill the gap.

Some viable alternatives may not be actual bonds at all. An example would be the loans in the business development space that generate high levels of dividend income. They potential carry more risk, but they generate much higher yields.

For example, FSK is a publicly-traded company that makes and manages business development loans. FSK has a dividend yield of 11.47% and is currently up 7.09% on the year. It’s riskier from a price movement perspective, but if you’re willing to accept some risk in return for a much higher level of income than you can get in most bond funds today, it’s an alternative that might make sense for you. If you’re more risk averse, you may need to look elsewhere.

Types of Mutual Fund Bonds

As mentioned earlier, it’s important to remember that the bond market is much larger than the stock market. Because there are so many different types of bonds available, there are several types of mutual bond funds to consider that are quite unique in their on way. They respond differently to rising interest rates and inflationary pressures.

Investment-Grade Corporate Bonds

Investment-Grade corporate bonds are issued by corporations to raise operating capital. These are high quality bonds issued by large corporations, and as such have a low level of risk and likely lower yields. Bond funds in this space provide investors an opportunity to utilize a diversified grouping of corporate bonds to mitigate risk.

High-Yield Bonds

These are also known as junk bonds, as they consist of lower-quality bonds that pay a larger coupon to attract bond buyers. Since they are lower quality, they’re more susceptible to risk in the markets and tend to behave more like stocks than bonds. Grouping them together in a fund helps mitigate the risk of default by spreading the risk among several issuers.

Treasury Inflation-Protected Securities (TIPS) Bonds

There’s a good chance you’ve probably heard about TIPS recently if you’ve been tuning into America’s Wealth Management Show. With inflation continuously hitting 40-year highs, TIPS have been popular considering that they’re designed to protect against inflation. These bonds are adjusted twice a year based upon the readings of the Consumer Price Index.

Generally, these are shorter duration to keep the price volatility to a minimum. The zero-to five-year TIPS ETF is up by 0.24% on the year and has a yield of 5.29%. Just the kind of thing you need to help get through the volatility we’re seeing today.

“Inflation-protected treasuries, especially the short duration ones, are going to be a good place to be. The reason the market is so volatile right now is because everybody thinks that there’s already going to be pressure on economic growth,” Dean said. “If the Fed goes too far too fast, it puts the economy into a recession. And if that happens, then interest rates are going to drop and bond mutual funds are going to make a lot of money.”

Municipal Bonds

Municipal bonds generate income that isn’t subject to federal, state, and some local taxes. They are issued by municipalities, typically states and cities. They are either backed by the general taxing authority of the municipality or by the revenue generated by the project the bonds are funding. Examples of that could include a water treatment plant or sewer system. In times of recession when raising taxes is not sound policy, the revenue-backed municipal bonds are typically safer than their counterparts that rely on the taxing authority of the municipality.

Could We See a Bond Bear Market?

The thing we need to ask ourselves is where do interest rates go from here? When the Federal Reserve starts talking about changing interest rates, they’re talking about changing the Fed funds rate, which is overnight bank-to-bank lending.

“Some of the Fed presidents are saying they want to reach 3% to 3.5% by the end of the year on that bank-to-bank rate. If that goes to 3% to 3.5%, our 10-year treasuries are probably going to 4% to 4.5% unless you get an inverted yield curve like we experienced a few weeks ago,” Dean said. “There is a high possibility that we get another 1% or more move on the 10-year treasury over the next 12 months. That means that people that are already down 10% in bonds could be done another 10%. We could see the first bear market in bonds in 40 years. It’s all the more reason to be diligent in allocating your fixed income part of your portfolio.”

Interest Rates, Inflation, and Uncertainty

The late Paul Volcker led the charge 40 years ago in the quest to fight off rampant inflation. Now, the hope is that current Federal Reserve Chairman Jerome Powell can do the same. However, everyone isn’t in agreement with thinking that Powell will need to be as aggressive as Volcker was with raising interest rates to slow inflation. Federal Reserve Governor Christopher Waller stated, “We know what happened for the Fed not taking the job seriously on inflation in the 1970s, and we aren’t going to let that happen. They had zero credibility, so Volcker just basically said, ‘I’ve got to just do this shock and awe.’ We don’t have that problem right now. This is not a shock-and-awe Volcker moment.”

While the Fed claims that it will do its best to slow inflation, we must remember that there are factors that are out of the Fed’s control that may derail the economy and their plan to continue raising interest rates. One of the biggest variables for the past few months has been the war between Russia and Ukraine and the geopolitical uncertainty that’s ensued. If the end result of the supply shortages that are a result of the conflict is a recession or prolonged market crash, the Fed will likely reverse course to limit the damage. Or, if their planned hikes tip the economy into a recession and cause a market crash, the response would more than likely be the same.

Given all that, it’s essentially impossible to predict where interest rates are going to end up. But for now, we know the intended direction, which is the only thing we can plan for at this time.

Bonds Remain an Essential Part of Your Portfolio

Again, while it might seem hard to believe right now, bonds are still a key component to your portfolio. We also want to remind you that we aren’t mentioning specific funds as recommendations or advice. We are bringing them into this conversation for your educational benefit. It’s critical to have a conversation with your investment or tax professional prior to making any financial decisions.

Knowing What You Own

Obviously, if you’re planning to retire soon or are in retirement, this market volatility can be that much more concerning. Dean says that this is especially the case for soon-to-be retirees with target date funds, which are losing money due to the poor performances of traditional bonds. It doesn’t help that the target date funds have become the default for 401(k) plans.

“The target date retirement 2025 fund is -10%, while the S&P 500 is -4%. So, you can have all your money in the stock market over the last 12 months and be better off than that target date 2025 fund,” Dean said. “There’s no guarantee in target date retirement funds because they’re going to own treasuries in there that are getting smoked. And they won’t change it because it’s an asset allocation model that’s designed to have certain things in it all the time regardless of what’s going on.”

You Can’t Just Set It and Forget It with Your Portfolio

Active management with your portfolio today is critical. As the economic landscape changes, seemingly daily, being proactive and tactical is a better plan than being passive. There is no question that things will look completely different by this time next year. The only question is what will they look like? Will they require a new strategy to navigate the risks? Will the markets be moving up instead of down? Could the Fed successfully walk the line between fighting inflation and avoided recession? Will the supply chain shortages be just a bad memory?

There are so many moving parts right now. It’s important to realize that using a set-it-and-forget-it strategy with your portfolio right now will end up costing you money. We’re here to help you navigate those moving parts.

Our CFP® professionals can do an analysis to help determine what bonds, bond funds, and bond alternatives could best fit in your financial plan based on your personal goals and objectives. If you have any questions about bond mutual funds and how they might work for you, you can schedule a 20-minute “ask anything” session or a complimentary consultation with one of our CERTIFIED FINANCIAL PLANNER™ professionals. They can meet with you in person, over the phone, or virtually.

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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.