What Happens to Your Bond Fund When Interest Rates Rise

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Many bond-fund investors are anxious about the effects on their holdings as the Federal Reserve boosts short-term interest rates, a process the central bank may start this month.

For good reason: When rates in the marketplace rise, the prices of older bonds with lower rates fall.

But over a period of years, bond-fund investors will do better in an environment of rising interest rates than in one in which rates stay at today's unusually low levels.

That because as the bonds in funds' portfolios mature, managers will reinvest in newer issues with higher interest rates, and investors will benefit from increased income. In addition, the interest payments from the bonds in the portfolio will be reinvested at higher rates.

"An initial rate increase could cause pain in the short term," says Joshua Barrickman, head of fixed-income indexing, Americas, at Vanguard Group. "But over the long term, it will act to your benefit."

At The Wall Street Journal's request, Vanguard looked at the math for a hypothetical investor in intermediate-term bond funds. These are one of the most popular types of bond funds, generally investing in investment-grade bonds which mature within four to 10 years. For simplicity, the Malvern, Pa., fund company assumed the Fed raises short-term interest rates by 0.25 percentage point in January, and then makes a similar-sized increase every other quarter through July 2019, for a total climb of two percentage points spread over eight increases.

Under that scenario, a typical intermediate-term bond fund would lose a modest 0.15% next year but generate positive yearly returns thereafter, Vanguard found. The figures are total returns including price change and income.

Over the first several years, investors would earn less than if rates remained at current levels. But starting in the second quarter of 2023--more than three years after the end of the rate increases--investors in such a fund would be ahead of where they would have been had there been no rate increase, Vanguard found.

If rates were to climb more quickly, the funds could suffer steeper initial losses. But that's unlikely as the Fed has repeatedly indicated that rate increases will be gradual.

"Intermediate-term bond-fund investors may feel a little sting, but it's certainly not going to be a bleed-out," says Marilyn Cohen, chief executive at Envision Capital Management Inc., a registered investment adviser that specializes in individual bonds.

She notes that the Fed has telegraphed a rate increase so well that few investors should be surprised. If investors were taken by surprise, they might be more likely to pull large sums out of bond funds, which could have the effect of exacerbating bond price declines.

Investors in bond funds are generally very long-term investors who hold the funds for their ability to absorb volatility and/or for the income they throw off, says Mr. Barrickman of Vanguard. Vanguard investors didn't do any meaningful selling in prior periods of rising rates, the firm says, and no panicky selling is expected this time.

The Fed is well aware of the importance of setting investors' expectations, says Jeff Tjornehoj, head of Americas research at Thomson Reuters Lipper. The central bank was clear about its intentions when it raised interest rates "pretty aggressively" from May 2004 through July 2006, and there were "fairly steady, if not heavy, inflows" into taxable bond funds, he says. But in 1994, when the Fed didn't communicate it was interested in raising rates and did so quickly, investors pulled $33.3 billion overall from taxable bond funds, Mr. Tjornehoj says.

"That's the period the Fed does not want to relive," he says.

It's impossible to know exactly how various types of bonds will perform when the Fed raises its target for short-term rates. One question is whether long-term rates follow short-term rates upward. While the Fed controls short-term rates, supply and demand in the market determine long-term rates.

Bonds of varying credit quality also may perform differently.

"To predict how these bond funds will react is really a difficult game to play," says Sumit Desai, senior fixed-income analyst at Morningstar Inc. "It's important for advisers and individual investors to at least understand that there's a little bit of uncertainty within the space."

"Whether investors believe the Fed is acting too quickly, too slowly, or perhaps not enough can make all the difference," Eric Jacobson, a senior analyst at Morningstar, wrote recently. Other factors at play today include "a relatively weak global economic outlook and strong overseas demand for long-term Treasurys," he said. "That makes it extra tricky to predict how funds will fare when the Fed chooses to act."

Another factor to consider: Many bond-fund managers have bought shorter-term bonds and taken other steps to make their portfolios less sensitive to an interest-rate increase than they might have been otherwise, says Lee Partridge, chief investment officer at Salient, an asset manager based in Houston.

Investors should keep in mind that the Fed may not raise rates at all this year; it has surprised pundits before.

Write to Daisy Maxey at daisy.maxey@wsj.com

(END) Dow Jones Newswires

December 02, 2015 07:00 ET (12:00 GMT)

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