Rising Interest Rates Pose Risk for Bond Funds -- Here Is What You Can Do

In this segment from Motley Fool Answers, Alison Southwick and Robert Brokamp dive into bonds to get a grip on an interesting question from one of their listeners. His ask:

The team discusses laddering and how to play bonds in an environment when interest rates are rising and yields falling.

A transcript follows the video.

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This podcast was recorded on Nov. 22, 2016.

Alison Southwick:All right, it's time for Answers, Answers and today's question comes from Steve. Are we sure this isn't Steve Broido?

Robert Brokamp:It's not Steve Broido.

Southwick:Our in-house bond expert?

Brokamp:No.

Southwick:All right. Steve writes: "I continue to hear about the risk that rising interest rates pose to traditional bond funds, as well as the benefits of laddering individual bonds, but I'm intimidated by picking and maintaining a portfolio of individual bonds. What are your thoughts on laddering target-dated maturity bond funds such as Guggenheim's corporate bonds or iShare's muni bonds?" All right, Bro. Make this interesting to me.

Brokamp:OK. Well, I don't know if I can do that, but, Steve, your concerns are valid. Interest rates are at historic lows. Just for an example, a 10-year Treasury, pretty much the main benchmark rate, in July hit historic lows. But when rates go up, the values of existing bonds go down. So actually, rates have gone up since July.

So if you look at, for example, theVanguard Total Bond Index Fund, the biggest bond fund in the world, it's actually down 3% over the last three months. And you think, "Well, bonds are safe. Oh, my goodness. My investment has dropped 3%," so this is a concern for anyone who's looking for an alternative to the stock market.

Some people will recommend individual bonds. You buy a bond for, let's say, $1,000. A five-year bond. Rates go up. The value of it in the marketplace will go down, but as long as you hold it to maturity and the company is still in business, you'll get your $1,000 back in five years.

Southwick:And that is what we talked about with the Steve Broido episode.

Brokamp:Right, exactly. Bond funds, though, fluctuate in value. You don't know what you're going to get. But buying individual bonds can be complicated and you do have to own many to be specially diversified.

So a company called Guggenheim, and then followed by iShares, came up with a solution. They have what are calledtarget-date maturity bond fundsin that you buy, for example, the 2018 bond fund and it only holds bonds that mature in 2018. At the end of 2018, you just get all your money back, because all the bonds have matured.

Southwick:Oh!

Brokamp:So it's a way to get the benefits of holding individual bonds but instant diversification, so it's actually a pretty good deal.

Let's take a look very quickly at the bond fund that's going to mature this year, 2016. It matures at the end of the year. Over the last five years, it has earned an average of almost 3% a year. That's about what the overall bond market has earned, so that's good. And when you compare it to -- I mentioned that Vanguard is the biggest bond fund -- the second biggest bond fund,PIMCO Total Return, that's actually earned a little over 3% a year. The next is NatWest. The total return -- that's earned over 4% a year.

So while I like these Guggenheim target-date bond funds, you probably won't get the same returns as you might get with another type of fund, but you also won't get the fluctuation. I mentioned how a lot of bond funds have actually come down over the last three months. This 2016 Guggenheim fund has actually made a little bit of money. Why? Because it's 2016. This is the year these bonds are maturing, so actually half that bond is already in cash, because those bonds have matured.

So I think it's a great option if you are looking for something that's going to earn a little bit more than cash. You want a little bit more security about the money. But over the long term, I don't think that they will have quite the same returns as a traditional diversified bond fund that you hold for the long term.

Southwick:Can you address the laddering part? I kind of understand laddering.

Brokamp:Laddering is you buy different bonds -- and you can do it with CDs, too -- of different maturities. So maybe you put some of your money in a bond that matures one year, then two years, three years, four years, and five years. Every year you have bonds coming due -- so you have some liquidity there -- but you also have some bonds that are longer dated, because the longer the bond is, the higher interest rate you're going to get.

Southwick:And every year that they mature, then you buy another year out.

Brokamp:Right, exactly. And these target-date ETFs actually can be good for that. In fact, on Guggenheim's website, you even have a tool in there where you put in how long you want your ladder to be, how much you want to put in your ladder, and it will tell you which ETFs to buy and how much to invest in those ETFs.

Southwick:So generally speaking, bottom line, not a bad idea, Steve.

Brokamp:Not a bad idea. Especially if you're retired and you want to protect money that you need in the five years, it's a great idea. If you're just buying bonds for diversification to your long-term portfolio, a regular bond fund is probably OK.

Alison Southwick has no position in any stocks mentioned. Robert Brokamp, CFP has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.