Why Bonds Funds Aren’t Necessarily A Losing Proposition In Rising Rate Environments

With interest rates hovering around multi-decade lows, investors have been increasingly concerned about the consequences to bonds when the “inevitable” shift happens and rates begin to rise. As the simple math of bonds makes clear, rising interest rates will drive down bond prices, potentially to the point of creating negative total returns for bonds.

To defend against this risk, an increasing number of advisors have been shifting to buying individual bonds in lieu of using bond funds. Given that bond funds tend to target a consistent maturity, in a rising rate environment the potential exists that bond funds will “lock in” bond price losses annually, while holding individual bonds until maturity allows for the investor to be assured that the bond will not face capital losses and will eventually mature at par value.

Yet the reality is that in an upward-sloping yield curve environment, rolling bonds to maintain a constant maturity is actually an enhancement to total return… enough that even if rates do rise, funds that roll bonds down the yield curve may still outperform the hold-to-maturity bond investor! And the steeper the yield curve becomes, the greater the benefit to sticking with bond funds after all.

Of course, the reality is that if rates spike “enough”, there is still risk that funds rolling their bonds will underperform just holding individual bonds until maturity. But on the other hand, trying to avoid rising rates by buying individual bonds is still at best a risk-return trade-off, as investors give up a “known” potential to roll down the yield curve for greater returns against just the potential that interest rates may, eventually, rise far enough and fast enough to offset the benefit!

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Written By: Michael Kitces

August 24, 2015 In: Financial Articles Comments (None)