When the Federal Open Market Committee raised the federal funds rate by a quarter of a point in March, many investors wondered what impact this might have on their portfolios. We, at Frontier, have noticed many bond investors, in particular, have been questioning the impact of rising rates on bond mutual funds and exchange traded funds (ETFs).
Bond Prices and Interest Rates
To understand how rising rates affect bonds, you first need to understand the inverse relationship between bond prices and interest rates. In other words, when interest rates rise, bond prices fall, and vice versa. So if the Federal Reserve continues to raise rates as it has indicated it will, bond prices will fall in the future.
The next thing you need to understand is what’s referred to in bond terminology as duration. Morningstar defines bond duration as “a time measure of a bond’s interest-rate sensitivity, based on the weighted average of the time periods over which a bond’s cash flows accrue to the bondholder.” A bond’s duration is usually shorter than its maturity.
In general, the longer a bond’s maturity, the higher its duration will be. And the higher its duration, the more sensitive a bond’s price will be to rising or falling interest rates. Conversely, the shorter a bond’s maturity, the lower its duration will be and the less sensitive its price will be to rising or falling rates.
A bond mutual fund’s or ETF’s duration will be listed on its fact sheet, which you can find on its website.
So What Does This Mean?
To get an idea of what this means, let’s look at an example. According to Morningstar, the effective duration of the Vanguard Total Bond Market Index, which tracks the aggregate U.S. bond market, is 6.05 years. So if interest rates rise by 1%, the value of the bonds held by the fund would probably fall by approximately 6.05%.
Keep in mind, though, that there are other factors beyond interest rates that can affect bond prices. For example, at the outset of the financial crises in 2008, many investors moved money out of bond funds and into Treasuries for safety. Many high-quality bond funds and ETFs sustained major losses in 2008 due simply to this large outflow of money into Treasuries.
A bond’s coupon rate (or its stated interest rate) will also affect duration. The higher the coupon rate, the lower the duration. The total long term return of a bond fund or ETF will be determined by income payments and interest rate movements. Bonds held in a mutual fund or ETF with lower coupons (i.e., interest rates) will be replaced over time by bonds with higher coupon rates.
Note that since bond mutual funds and EFTs hold portfolios of bonds, the funds and ETFs themselves do not mature like individual bonds do. Individual bonds are traded on the secondary market, and like individual stocks, their prices are based largely on supply and demand.
And What Should You Do?
Based on all of this, should you remain in or exit bond mutual funds and ETFs? Bond funds and ETFs could have a place in your portfolio, but there’s no one-size-fits-all answer that’s right for every investor. It will depend on your particular circumstances and investing goals.
Please contact us if you have more questions about bond duration and whether or not bond mutual funds and ETFs have a place in your portfolio.