Bond Funds in Rising Interest Rate Environment

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
User avatar
Topic Author
53timr
Posts: 216
Joined: Sat Dec 27, 2014 3:27 pm

Bond Funds in Rising Interest Rate Environment

Post by 53timr »

With all the "talking head" financial gurus talking about the rising interest rate environment for bonds, I find that I do not really understand bond funds and ETFs as well as I understand stocks. In a traditional IRA I hold about $180k in the Fidelity Spartan U. S. Bond Index (FSITX). I also have some bond exposure in my Fidelity 401(k) plan invested in the Vanguard Balanced Index (VBIAX). I am a couple of years away from retirement, but will be looking for my bond investment to generate a little income for me when I do retire.

I understand that if interest rates rise, the price of an existing bond will go down. If an investor owns individual bonds and holds them to maturity he will recover his initial investment and can reinvest in higher interest rate bonds, but what is the real effect on someone who is invested in a bond fund or ETF?

From the reading I have done, it would seem that the value of a bond fund would decrease as interest rates rise. As interest rates continue to rise, the fund would continuously have bonds maturing that would then be reinvested in higher rate bonds. After the initial dip it would seem that bond funds would recover over some period of time.

So, am I missing something here? It looks to me like bond funds are still a reliable investment over time and it appears I should keep my bond investment as is. It seems like the only reasonable alternative is to invest in individual bonds but that involves a lot of time and effort in research.
“I take my investment advice from my dentist, because he’s just as likely to lose me money as a financial advisor.” | ― Jarod Kintz, This Book Title is Invisible
livesoft
Posts: 86973
Joined: Thu Mar 01, 2007 7:00 pm

Re: Bond Funds in Rising Interest Rate Environment

Post by livesoft »

Since you understand stocks more than bonds, first please tell me what will happen to your stock funds in a rising interest rate environment.
Wiki This signature message sponsored by sscritic: Learn to fish.
kolea
Posts: 1322
Joined: Fri Jul 11, 2014 5:30 pm
Location: Maui and Columbia River Gorge

Re: Bond Funds in Rising Interest Rate Environment

Post by kolea »

I think you have summed it up very well. Your understanding seems correct to me. I believe what alarms many people is captured in your statement here:
53timr wrote: From the reading I have done, it would seem that the value of a bond fund would decrease as interest rates rise.
The operative word there is "value". If held to maturity, the book value of the bonds within the fund has not changed at all - it is still the sum of the par values of all the bonds + interest payments. That was fixed and remains fixed. It is only the market value that has changed since people see that they can make more money with higher interest rate bonds. But if you are not actively trading, the market value has little effect on you other than looking like you are losing money because the NAV is down. But the NAV will recover. Investors just need to be patient. It helps of course to own short or intermediate duration bond funds since the NAV recovery is then quicker.
Kolea (pron. ko-lay-uh). Golden plover.
livesoft
Posts: 86973
Joined: Thu Mar 01, 2007 7:00 pm

Re: Bond Funds in Rising Interest Rate Environment

Post by livesoft »

53timr wrote:[…]
From the reading I have done, it would seem that the value of a bond fund would decrease as interest rates rise. As interest rates continue to rise, the fund would continuously have bonds maturing that would then be reinvested in higher rate bonds. After the initial dip it would seem that bond funds would recover over some period of time.

So, am I missing something here? It looks to me like bond funds are still a reliable investment over time and it appears I should keep my bond investment as is. It seems like the only reasonable alternative is to invest in individual bonds but that involves a lot of time and effort in research.
I don't think you are misssing anything except that your stock funds will also drop when interest rates rise. Also one must re-invest those monthly bond fund dividends and not spend them if one expects to mitigate the effects of losses in bond funds. That is, when the NAV of bond funds drop, one must buy low.

Did you notice that interest rates rose in the summer of 2013? What happened to your FSITX then? Did it recover?
Wiki This signature message sponsored by sscritic: Learn to fish.
User avatar
Rx 4 investing
Posts: 735
Joined: Sat Apr 25, 2015 11:03 am

Re: Bond Funds in Rising Interest Rate Environment

Post by Rx 4 investing »

Good counsel to this point.

I often refer to this article by Rick Ferri who believes most of us are better off sticking with intermediate-term in a rising rate environment to maximize yield and total return. In his article from last summer (BTW-the experts were predicting higher rates back then too), he points out that taking cover in short-term bonds usually doesn't work out well.

http://www.rickferri.com/blog/investmen ... ond-funds/
“Everyone is a disciplined, long-term investor until the market goes down.” – Steve Forbes
livesoft
Posts: 86973
Joined: Thu Mar 01, 2007 7:00 pm

Re: Bond Funds in Rising Interest Rate Environment

Post by livesoft »

Rx 4 investing wrote:..., he points out that taking cover in short-term bonds usually doesn't work out well.
But the chart shows that it did work out fine:
Image
Wiki This signature message sponsored by sscritic: Learn to fish.
User avatar
nisiprius
Advisory Board
Posts: 53155
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Bond Funds in Rising Interest Rate Environment

Post by nisiprius »

I don't think you're missing anything. A couple of points that occur to me:

a) We do not know that we are in "a rising interest rate environment." We probably are. If we had to bet I'd say we are. But we don't know. In April of 2014 Bloomberg surveyed 67 economists as to what they expected to happen to the 10-year Treasury yield over the next six months. 67 of them expected it to rise, 67. In fact, it fell. I don't know, you don't know, he, she, or it don't know, we don't know, you-all don't know, they don't know.

b) It momentarily surprises people, when first introduced to bonds, to realize that if interest rates rise sharply, the market value of their bond falls. I guess because it's important, and surprising until you think about it, that people seem to fixate on this detail and overemphasize it. It is a temporary decrease in the market value... the stream of interest payments is unaffected... and that the value of the bond must rise to the face value at maturity, while reinvested interest payments continue to create a source of return that is independent of the capital value.

As important as the "interest-rises-bonds-fall" fact is, an equally important fact is that the duration of the bond represents a "point of indifference." If stocks become somewhat less risky in the indefinite "long run," the Vanguard Total Bond Fund becomes much less risky if you are willing to hold it for 5.6 years.

c) Even a small risk is undesirable if you don't have to take it. When talking about bond funds the question is "what is the alternative?" The most obvious alternative is bank CDs. This alternative doesn't get much discussion in the investment media because all the talk is about products that brokerages, rather than banks, sell. I mention bank CDs only in the sense that they should be seriously considered. I am sticking with Total Bond myself but that's because I place a very high value on simplicity and convenience.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
pkcrafter
Posts: 15461
Joined: Sun Mar 04, 2007 11:19 am
Location: CA
Contact:

Re: Bond Funds in Rising Interest Rate Environment

Post by pkcrafter »

53timr wrote:With all the "talking head" financial gurus talking about the rising interest rate environment for bonds, I find that I do not really understand bond funds and ETFs as well as I understand stocks. In a traditional IRA I hold about $180k in the Fidelity Spartan U. S. Bond Index (FSITX). I also have some bond exposure in my Fidelity 401(k) plan invested in the Vanguard Balanced Index (VBIAX). I am a couple of years away from retirement, but will be looking for my bond investment to generate a little income for me when I do retire.

I understand that if interest rates rise, the price of an existing bond will go down. If an investor owns individual bonds and holds them to maturity he will recover his initial investment and can reinvest in higher interest rate bonds, but what is the real effect on someone who is invested in a bond fund or ETF?

From the reading I have done, it would seem that the value of a bond fund would decrease as interest rates rise. As interest rates continue to rise, the fund would continuously have bonds maturing that would then be reinvested in higher rate bonds. After the initial dip it would seem that bond funds would recover over some period of time.

So, am I missing something here? It looks to me like bond funds are still a reliable investment over time and it appears I should keep my bond investment as is. It seems like the only reasonable alternative is to invest in individual bonds but that involves a lot of time and effort in research.
I think you have a very good perspective. Consider that Vanguard's total bond index holds 1640 bonds with an annual turnover of 72%. What will happen if rates rise is the price of the bonds will immediately drop, but some of Vanguard's bonds will mature in a short time and some will be sold and replaced with newer, higher rate ones. Simple, but rising rates usually don't stop with one adjustment, so there may be multiple steps to overcome. Even at that, Vanguard's data show that a full recovery occurs in a time line with the duration of the fund.

I really don't know what all the fuss is about. Anyone who worries about bond risk while not thinking about stock risk is missing something. A risk you can see and calculate is not as worrisome as one that carries much higher losses and you don't see coming.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
User avatar
ogd
Posts: 4876
Joined: Thu Jun 14, 2012 11:43 pm

Re: Bond Funds in Rising Interest Rate Environment

Post by ogd »

53timr wrote:From the reading I have done, it would seem that the value of a bond fund would decrease as interest rates rise. As interest rates continue to rise, the fund would continuously have bonds maturing that would then be reinvested in higher rate bonds. After the initial dip it would seem that bond funds would recover over some period of time.
A fund does not have to replace bonds to get higher yields. They simply become higher yielding (coupon is the same, but YtM is higher) as soon as the price drops. More details on this and your question in recent post of mine: http://www.bogleheads.org/forum/viewtop ... 0&t=165931 .
53timr wrote: It seems like the only reasonable alternative is to invest in individual bonds but that involves a lot of time and effort in research.
Individual bonds do not avoid interest rate risk at all vs a fund of the same duration. More details in this other recent post: http://www.bogleheads.org/forum/viewtop ... 9#p2488694

An instrument that does (minus a small penalty) is a bank CD. The key is allowing you to withdraw early at face value, or close to it. With the tradeoff of logistics.
livesoft wrote:
Rx 4 investing wrote:..., he points out that taking cover in short-term bonds usually doesn't work out well.
But the chart shows that it did work out fine:
Image
Not if you compare apples to apples. I am too lazy to post graphs, but in your period the refuge of VCSCX vs VICSX cost you 6%. The refuge of VBIRX vs VBILX cost 4.8%.

And definitely not if you were early. Since 2010 (when the "rising interest rate environment" began including in the reckoning of Dr Bernstein), the numbers are pretty ridiculous: -24% in both cases. These "bad timing" losses are by now impossible to make back through loss avoidance.

Granted, short bonds did have reduced risk throughout the period. But boy did it cost you.
ncole1
Posts: 163
Joined: Wed Feb 27, 2013 8:44 pm

Re: Bond Funds in Rising Interest Rate Environment

Post by ncole1 »

ogd wrote:
53timr wrote:From the reading I have done, it would seem that the value of a bond fund would decrease as interest rates rise. As interest rates continue to rise, the fund would continuously have bonds maturing that would then be reinvested in higher rate bonds. After the initial dip it would seem that bond funds would recover over some period of time.
A fund does not have to replace bonds to get higher yields. They simply become higher yielding (coupon is the same, but YtM is higher) as soon as the price drops. More details on this and your question in recent post of mine: http://www.bogleheads.org/forum/viewtop ... 0&t=165931 .
53timr wrote: It seems like the only reasonable alternative is to invest in individual bonds but that involves a lot of time and effort in research.
Individual bonds do not avoid interest rate risk at all vs a fund of the same duration. More details in this other recent post: http://www.bogleheads.org/forum/viewtop ... 9#p2488694
Only if it is a defined maturity fund. If you buy a bond fund that rolls its bonds to keep duration roughly constant, then you will be hurt if interest rates rise sharply just before you plan on pulling the money out.

By contrast, a defined maturity fund that matures when you want to get the money out has zero net interest rate risk.
User avatar
ogd
Posts: 4876
Joined: Thu Jun 14, 2012 11:43 pm

Re: Bond Funds in Rising Interest Rate Environment

Post by ogd »

ncole1 wrote:Only if it is a defined maturity fund. If you buy a bond fund that rolls its bonds to keep duration roughly constant, then you will be hurt if interest rates rise sharply just before you plan on pulling the money out.

By contrast, a defined maturity fund that matures when you want to get the money out has zero net interest rate risk.
Please read the second linked thread which talks about this in detail. Here's the link again: http://www.bogleheads.org/forum/viewtop ... 9#p2488694

Here are two simple proofs that the DM fund has right now interest rate risk proportional to a normal bond fund of the same duration:
1) Whatever happens to interest rates in the next, say, 3 months -- including bond armageddon -- I can still trade the same number of the normal bond fund for the same number of the DM fund. If this doesn't mean "same risk", I don't know what does.
2) Under the bond armageddon scenario, a person holding cash would be in a far better place than the person holding DM fund shares -- e.g., the cash holder can buy a lot more DM shares. We call the difference between these two positions interest rate risk. The DM fund definitely has it. It's only cash or "early withdrawal" instruments that have "net zero" risk.
User avatar
Topic Author
53timr
Posts: 216
Joined: Sat Dec 27, 2014 3:27 pm

Re: Bond Funds in Rising Interest Rate Environment

Post by 53timr »

Thanks everyone for the good discussion points and links!
“I take my investment advice from my dentist, because he’s just as likely to lose me money as a financial advisor.” | ― Jarod Kintz, This Book Title is Invisible
User avatar
sperry8
Posts: 3080
Joined: Sat Mar 29, 2008 9:25 pm
Location: Miami FL

Re: Bond Funds in Rising Interest Rate Environment

Post by sperry8 »

nisiprius wrote:I don't think you're missing anything. A couple of points that occur to me:

a) We do not know that we are in "a rising interest rate environment." We probably are. If we had to bet I'd say we are. But we don't know. In April of 2014 Bloomberg surveyed 67 economists as to what they expected to happen to the 10-year Treasury yield over the next six months. 67 of them expected it to rise, 67. In fact, it fell. I don't know, you don't know, he, she, or it don't know, we don't know, you-all don't know, they don't know.

b) It momentarily surprises people, when first introduced to bonds, to realize that if interest rates rise sharply, the market value of their bond falls. I guess because it's important, and surprising until you think about it, that people seem to fixate on this detail and overemphasize it. It is a temporary decrease in the market value... the stream of interest payments is unaffected... and that the value of the bond must rise to the face value at maturity, while reinvested interest payments continue to create a source of return that is independent of the capital value.

As important as the "interest-rises-bonds-fall" fact is, an equally important fact is that the duration of the bond represents a "point of indifference." If stocks become somewhat less risky in the indefinite "long run," the Vanguard Total Bond Fund becomes much less risky if you are willing to hold it for 5.6 years.

c) Even a small risk is undesirable if you don't have to take it. When talking about bond funds the question is "what is the alternative?" The most obvious alternative is bank CDs. This alternative doesn't get much discussion in the investment media because all the talk is about products that brokerages, rather than banks, sell. I mention bank CDs only in the sense that they should be seriously considered. I am sticking with Total Bond myself but that's because I place a very high value on simplicity and convenience.
Very helpful post! Thank you for explaining bonds to me in this environment in a way I can understand. I guess now I must look at bank CDs vs bonds in this environment against my expected holding period so I can make an informed decision. At least now I have a plan of attack!
BH Contests: 23 #89 of 607 | 22 #512 of 674 | 21 #66 of 636 |20 #253/664 |19 #233/645 |18 #150/493 |17 #516/647 |16 #121/610 |15 #18/552 |14 #225/503 |13 #383/433 |12 #366/410 |11 #113/369 |10 #53/282
firstar
Posts: 2
Joined: Tue Jun 04, 2024 4:14 pm

Re: Bond Funds in Rising Interest Rate Environment

Post by firstar »

I've read about duration and the point of indifference. The example scenarios in my reading have one interest rate increase. Let's say the bond duration is 10 years, and there is an increase in rates right after the bond is purchased. If the coupons are reinvested we are at a break even point in 10 years. Okay, that seems logical.

Now let's suppose that there was a 2nd interest rate increase at the 5 year mark. Is the new break even point now 15 years after the bond was initially purchased? If so, then do you simply tack on 10 years with every increase in interest rates to arrive at a new break even point?
Post Reply