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Portfolio > Mutual Funds > Bond Funds

Under the Hood: Bond Investing—Preparing for Rate Increases

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Zacks Investment Research estimates that the size of the global bond market in 2010 was $93 trillion compared to $54 trillion in stocks. In the U.S. alone, bonds totaled just under $37 trillion in 2012 compared to stocks at $21 trillion. In short, the size of the bond market is substantial and, considering the fact that a rising interest rate environment is looming, it seems appropriate to continue our discussion of this important asset class.

In this article, we’ll look at the bond market before the crisis and compare it to where we are today. In the next article we’ll discuss two very important concepts pertaining to fixed income securities: duration and convexity

The Way We Were

When the financial crisis hit in 2008, risky assets were like a rolling cloud of sinking death, and bonds, although at the end of a long bull run, became the benefactor of billions of investor dollars. I suppose reversion to the mean took a brief hiatus. Over the next few years, as high-quality bonds grew in popularity, it became a crowded trade, pushing prices higher and yields lower. This forced investors to seek yield elsewhere. It also created a migration to lower credit-quality issues, until this too became overbought. At that time, yield was as scarce as an honest politician.

Today, with rates at all time lows, the prospect for bonds is one of greater risk and low reward. When rates finally rise, bond losses could be much greater than is found in the typical bond correction.

Let’s turn our attention to the present day. 

The Current Climate

Given the global macro economic outlook and the yield on other fixed income securities, notably the German Bund, the yield on the 10 year U.S. Treasury has been declining recently. Interest rates have been at all-time lows for the better part of the past seven years. As a result, bond funds with short maturities have already said farewell to the higher coupon issues they once held.

Intermediate-term bond funds have had a similar experience as the majority of the bonds they held prior to 2008 have matured and have been replaced with lower-yielding issues. Long-term bond funds are the only bond fund category still holding higher-yielding securities which existed prior to the crisis. To restate, most high-quality bond funds have a lower average coupon than they had prior to the crisis. Therefore, when rates rise, the lower coupon will provide less protection. 

The Problem

When rates rise, the bonds that will be hardest hit will be those with long maturities (i.e. long duration) and low coupons. The coupon will do little to insulate against falling bond prices and bonds with longer durations will experience the greatest loss.

If you happen to hold some of these bonds with low credit quality (e.g., high yield) when rates rise, the loss could be even worse, especially if we have a weak economy and a higher default rate at the same time.

Holders of bond funds will likely have more severe losses since funds have an additional risk: redemption risk. This is what occurs when interest rates rise and investors sell as they see the fund’s NAV fall. Redemption risk coupled with interest rate risk (i.e,. the risk of rising rates) is a lethal combination.

The following table illustrates the approximate amount of price decline for bonds with various durations. As mentioned, in Part II we’ll go into detail on duration and convexity.

Click to enlarge

For example, as a general rule of thumb, the price of a bond with a duration of 10 years will decline about 20% if interest rates rise by 2%.

So when interest rates rise, where do you want to be? 

Escaping the Rising Rate Trap

Since longer maturities, lower coupons and lower credit quality carry the greatest risk, it stands to reason that you should invest in high-quality, short-term bonds. However, this is quite obvious and has become a crowded trade. Nevertheless, I would still recommend it for a portion of the bond exposure. 

Managers of bond funds that can go negative duration are another option. In short, these bond managers can short the U.S. Treasury in an attempt to capture positive returns when interest rates rise. 

If you buy foreign bonds, you may want to hedge the dollar. You may also want to avoid emerging markets as this asset class tends to underperform when the Fed tightens. Basically, anything foreign is more risky with the strengthening greenback. Bank loan funds are another option as they invest in short-term securities, typically with 90-day maturities. However, many of these funds invest in lower credit quality issues so be careful and know what you’re buying.

If rising rates are also accompanied by rising inflation, inflation protected securities, or TIPS, may be a good choice. Even so, I’d stay short on the maturity until rates stabilize.

The following table contains the average returns for 2014 on an annual and per calendar quarter basis for several mutual fund bond categories in Morningstar’s database.

Click to enlarge

Notice how the first half of 2014 was much kinder to investors than the latter half for these categories. Also note how Emerging Market Bonds declined in the latter half of the year as the dollar strengthened. In general, all but two categories had a difficult year. The best performers were long-term and intermediate-term bonds. However, both were negative in 2013. 

With cash at zero, stocks near all time highs and bonds susceptible to rising rates, the future of the financial markets are anything but clear. When rates finally begin their ascent, many bond categories will experience losses. Therefore, it would be wise to give careful thought to the type of bonds you are holding or plan to acquire.

Unfortunately, there are no guarantees, but a little due diligence in advance will help minimize the damage. In the next article we’ll dive deeper into the world of fixed income securities with a discussion on duration and convexity.


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