Do you own one or more bond funds? If so, 2019 was a very good year, but don’t expect that to continue. You see, bonds do well when interest rates trend lower – as they did last year – but typically lose money when rates rise. And, with interest rates stuck at artificially low levels, at some point rates will rise, and bond funds will struggle to achieve a positive return. Here’s why.
Bond Prices and Interest Rates
Bond prices and bond yields move in opposite directions. Therefore, when interest rates rise, the price of an existing bond falls. To explain, let’s say you invest $10,000 in a 5-year bond with a 3.0% yield (coupon). You will receive $300 per year in interest (3.0% of $10,000), plus your original investment back at maturity. Now let’s assume that it’s a year after your initial investment, interest rates have risen, and newly issued bonds with a similar maturity are paying 5.0%. All else being equal, which bond is most attractive? The 5.0% bond, since it pays a higher rate of interest. Because of this, the price or value of your bond would fall.
Bond Maturities and Bond Prices
Bonds differ in many ways, including maturity, type, credit quality, and other factors. As the table below demonstrates, there are three general bond categories based on maturity, each with its own degree of risk. Here, we will assume all other factors are equal, and focus solely on how rising interest rates affects bonds of different maturities.
Managers of bond funds invest in bonds of certain maturities (among other criteria) based on the type of fund they manage. For example, a manager of an intermediate-term bond fund will typically buy bonds with maturities between 2 and 10 years. All the bonds that were held in these funds before the 2008 crisis have matured and have been replaced with lower yielding bonds. Thus, the average yield on a bond fund today is much lower today than in the decades before the financial crisis. What’s the risk? How much have interest rates changed? Let’s examine this now.
Bond Yields Before and After Financial Crisis
The two charts below tell the story. Before the financial crisis (Chart A), the average yield on a 2-year U.S. Treasury was 6.70% and the average yield on a 10-year U.S. Treasury was 7.52%. After the crisis (Chart B), the average yield on the 2-year fell to 1.42% while the average yield on the 10-year dropped to 2.80%. Thus, in the post crisis period, average yields on 2- and 10-year treasuries have fallen by 5.28% and 4.72% respectively.
Bond Yields Before Financial Crisis
Bond Yields Post Financial Crisis
This bears repeating. Because yields have been much lower since the crisis and the higher yielding bonds once held by funds have been replaced with lower yielding issues, many of today’s bond funds are very vulnerable to rising interest rates.
Bond Funds: Higher Yield = Greater Protection
Here’s another example explaining why bond funds are risky today. Let’s assume we have the choice of investing in two bond funds. We’ll call them Fund A and Fund B. Fund A has an average yield of 5.0% and Fund B has an average yield of 3.0%. Each fund has the same average maturity. When yields rise, bond prices will fall. If rates rise over the next 12 months pushing bond prices lower by 5.0%, investors in Fund A would break even. Unfortunately, investors in Fund B would lose money because bond prices dropped by a greater percentage (5.0%) than the fund’s yield (3.0%).
While it is beyond the scope of this article to delve into every nuance affecting the performance of bond funds, suffice to say that when yields rise – and they certainly will at some point, bond funds with shorter maturities and higher yields will provide greater principal protection than funds with lower yields and longer maturities. Make sure you understand the risk in your bond funds so you can avoid this pitfall.