Relief washed over the bond market after the Federal Reserve decided to hold off on hiking interest rates. But many investors were left to wonder: Was it just a temporary reprieve?
The stakes are high for bond funds, which are supposed to be the safe part of our portfolios. Investors have been fretting for years that rates are set to rise, something that would knock down bond prices. And even though the Federal Reserve didn’t raise short-term rates last week, the majority of its policymaking committee still expects it to happen this year.
Even so, bond funds can still be a shock absorber, offering some stability when the stock market goes on another of its dizzying drops, fund managers say. They’re looking to offer reassurance following predictions for big losses for bonds. There’s just one caveat that even the most optimistic manager acknowledges: Bond funds won’t do as good a job as in prior years because they’re paying much less in interest.
Why rising rates are a fear: When interest rates rise, prices for existing bonds fall because their yields suddenly look less attractive. To see what rising rates can do to bond funds, look to 2013, when the yield on the 10-year Treasury nearly doubled in eight months. The average intermediate-term bond fund lost 1.4 percent. Investors can insulate themselves by buying individual bonds and holding them until maturity. But they would lose out on the extra income that a new, higher-yielding bond would have provided. Plus, most investors prefer a diversified fund portfolio of thousands of bonds.
Why bond funds can avoid big losses: The Federal Reserve controls interest rates for very short-term loans. It has less control over longer-term interest rates. A big factor influencing 10-year Treasury yields is where inflation and economic growth are heading, and neither looks all that strong. Add that together with the slow, steady pace that the Federal Reserve has promised for short-term interest rates, and fund managers expect longer-term interest rates to rise modestly and gradually.
In that scenario, bond funds could avoid losses. Their price will drop as interest rates rise, but the income they produce could help offset the declines. And the income could be reinvested in higher-yielding bonds.
Why expectations have to be lower than before: Bond funds have historically helped give a sense of security when the stock market plummets. But the 10-year Treasury yield is 2.15 percent today, down from 4 percent at the start of 2008, which means bond funds will likely provide less protection in the next steep decline for stocks.
Even if longer-term rates rise only modestly in coming years, they can still have quick jags up and down as the Federal Reserve returns rates to more “normal” conditions. That means bond funds likely won’t have the same placid returns as in prior years.
Numbers to consider: When choosing a bond fund, pay attention to its “duration.” That number shows how sensitive a fund is to changes in rates.
The largest bond fund has an average duration of 5.7 years, which roughly means that an immediate, 1 percentage point rise in rates would lead to a 5.7 percent drop in price.
