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What Happens to Bond Funds When Rates Go Up?

One recurring theme in emails from readers is that people are worried about what will happen to their bond funds when interest rates rise.

As we’ve discussed before, there is an inverse relationship between bond prices and interest rates. When interest rates rise, bond prices fall. And if you own a bond fund. the price of your fund will fall by the average duration of the fund. multiplied by the magnitude of the rise in interest rates.

But in the real world, there’s a little bit more going on than in the contrived hypothetical examples. In real life:

  • Interest rates don’t increase all at once, then stay put. Instead, rate changes occur over a period of time.
  • Meanwhile, you’re earning interest on the bonds, which helps to offset any price declines, and
  • Your reinvested fund dividends will be buying bonds that have higher yields.

So while we can calculate a very good approximation for how far a fund will fall when rates increase by Y% on a given day, that doesn’t necessarily reflect how the bond fund will perform if interest rates increase by Y% over a period of several months or years.

Take, for example, Vanguard’s Intermediate-Term Treasury Fund. It has an average duration of 5.2 years and an average maturity of 5.5 years. From 6/13/2003 to 3/28/2005, yields on 5-year Treasuries rose 2.4% from 2.08% to 4.48%. If that decline had happened all at once, the value of the fund would have fallen by somewhere in the

ballpark of 12.5%(2.4% rate increase, times 5.2 average duration).

But, because the rise in rates occurred over a period of 21 months, here’s what actually happened (chart courtesy of Morningstar ):

It’s hard to see the scale of the y-axis (click the image to see it in full-size), but the decline was much less than 12%. Over the period, a $10,000 initial investment fell to $9,885 (a decline of just 1.15%). At the worst point (the end of July 2003), the value was $9,454 (a decline of 5.46%).

There are two important takeaways here.

First, if interest rates rise very suddenly, a bond fund could indeed experience a sharp decline (depending on its duration). However, if interest rates rise very gradually over a period of a few years, the fund’s performance is likely to be simply flat — or just slightly negative or positive.

Second, if you hold the fund long enough (specifically, for a period of time longer than the fund’s duration), a rise in rates works out to your advantage because your reinvested dividends will be buying higher-yielding bonds. (And if you’re in the accumulation stage such that you’re regularly putting more money into the fund, your break-even point will come even sooner.)

In other words, an increasing rate scenario isn’t necessarily a catastrophe for bond investors. It depends how quickly rates rise, how far they rise, what the duration of your holdings is, and how long you will be holding them.

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Category: Forex

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