Fixed Income Investing: Bonds vs. Bond Funds in a Rising Rate Environment

Bonds have traditionally been considered a “safe” investment suitable for retirees and other investors with low risk tolerance. Investing in a bond “fund” is different in several crucial ways from investing in a bond, and investors need to understand that difference.

Standard convention for asset mixes

The standard convention in investing is to have some amount of your investment portfolio in Fixed Income Assets because they are “safer” (i.e., less risky). Depending on your age and risk tolerance you are told by professionals like me to invest as much as 70% of your retirement account in this asset class. Most people have this part of their portfolio in bond funds which are one of ten mutual fund choices typically offered in a 401K Plan. Since bonds offer a pre-determined rate of return and stocks do not, risk-averse folks generally put their money here. Makes sense right? Indeed it does, but only when interest rates are declining. Unfortunately, what you don’t hear much about is what happens to bond fund values in a rising interest rate environment. When interest rates rise, bond funds lose money. In fact, Vanguard tells you this in the Product Summary section of its Long-Term Bond Index Fund. They say, “Long-term bonds tend to be very sensitive to interest-rate changes, one of the fund’s key risks is that increases in interest rates may reduce the price of the bonds in the portfolio, which would reduce the fund’s share price”.

Think of it This Way - Bonds vs. Bond Funds in a Rising Rate Environment

To understand why this is, you first need to know a little bit about bonds. Normally this is where your eyes glaze over and you say to yourself, “Oh not bonds, I’ve tried and tried, but I never really ‘got’ bonds.” Well, here’s a different angle on the concept that might just click with you.

In its simplest form, understanding what happens to bond prices when interest rates rise or fall comes down to a simple mathematical equation where you only have to solve for one unknown. There are three factors in the problem:

• A, the bond’s price

• B, the yield or interest rate which is known and goes up or down when interest rates rise or fall

• C, the annual interest payment received by the bond holder and remains fixed for identical bonds

And therein lies the key to remembering which way bond prices move when interest rates change. Since C is a constant for like bonds, bond prices and bond yields are inversely related. When one of the two goes up, the other must go down.

A x B = C

A=Bond Price; B=Bond Yield; C=Interest Income

Or,

A=C/B

Bond Price = Yearly Income/Interest Rate

(As the denominator gets larger the quotient get smaller)

In mathematical terms, think like this. In the bond equation, one end of it is fixed and bond prices fluctuate at par around this point depending on the bond yield. For example, if you purchase a $10,000 bond at par value (or face value) with a coupon (yield) of 4%, your annual interest income is $400. If interest rates rise and a newly issued bond pays 4.5%, to match the prevailing market rate and to ensure that the buyer will receive the same interest amount of $400, the market value of your bond must decline to $8,889.

Bond Price x 4.5% = $400

BP = 400/.045 = $8,889 (That’s a more than 10% decline!!)

In the case above, with yields going up and the yearly payment having to stay the same at $400 that requires the price of the bond to drop to offset the higher interest rate (yield) being offered.

Does This Mean You Shouldn’t Invest in Bonds?

Absolutely not! And here’s why. Without getting into the details of your preference for government bonds, municipal bonds, or corporate bonds suffice to say, when you are a bond holder you receive a known amount of yearly income (interest income) on the loan (your investment) you give to the bond seller. Then at the end of the term you get your loan (principal) back in full. Stocks, even dividend-paying stocks, don’t promise the return of your principal. As interest rates rise and bond yields go up, so does your yearly interest payment.

So why doesn’t a bond fund’s value rise in the same environment?

Bond funds don’t make coupon payments, and a holder of the bond fund does not receive yearly interest income. What bond fund holders are looking for is a capital gain. In other words, the bonds held by bond fund holders must go up in price for them to realize a profit. The bonds held in the fund are often traded daily and rely on some pretty sharp guys to make “good” trades. But no matter how good they are, they can’t win in a rising rate environment. After all, it’s just math.

What Should the Fixed-Income Portion of my Retirement Portfolio Look Like?

In the current interest rate environment, at Wilson David Investment Advisors we prefer a combination of various duration, government and AAA rated Corporate bonds in lieu of bond mutual funds. Additionally, we would be suggesting products that provide some inflation protection. If you should have any questions about this article or are interested in discussing potential changes to your current holdings, please contact us at (803) 507-2613.

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Kathryn Hauer, a Certified Financial Planner™, adjunct professor, and financial literacy educator has written numerous articles and several books including the “11-Step, DIY, Comprehensive Financial Plan Workbook” and “Financial Advice for Blue Collar America.” She works to help clients and readers understand and act on complex financial information to keep them and their money safe. She functions as a strong advocate and guiding light for her clients as they move through a murky and unfamiliar financial world. Learn more at her website.