What Happens to Bond Funds When Rates Go Up?

This is from one of my favorite sources- The Oblivious Investor – Reeve
Posted: 23 Jan 2013 05:00 AM PST

One recurring theme in emails from readers is that people are worried about
what will happen to their bond funds when interest rates rise.

As we’ve discussed before, there is an inverse relationship between
bond prices and interest rates. When interest rates rise, bond prices
fall. And if you own a bond fund, the price of your fund will fall by the average duration of the fund, multiplied by the magnitude of the rise in interest rates.

But in the real world, there’s a little bit more going on than in the contrived hypothetical examples. In real life:

  • Interest rates don’t increase all at once, then stay put. Instead, rate changes occur over a period of time.
  • Meanwhile, you’re earning interest on the bonds, which helps to offset any price declines, and
  • Your reinvested fund dividends will be buying bonds that have higher yields.

So while we can calculate a very good approximation for how far a
fund will fall when rates increase by Y% on a given day, that doesn’t
necessarily reflect how the bond fund will perform if interest rates
increase by Y% over a period of several months or years.

Take, for example, Vanguard’s Intermediate-Term Treasury Fund. It has
an average duration of 5.2 years and an average maturity of 5.5 years.
From 6/13/2003 to 3/28/2005, yields on 5-year Treasuries rose 2.4% from
2.08% to 4.48%. If that decline had happened all at once, the value of
the fund would have fallen by somewhere in the ballpark of 12.5%(2.4%
rate increase, times 5.2 average duration).

But, because the rise in rates occurred over a period of 21 months, here’s what actually happened (chart courtesy of Morningstar):

It’s hard to see the scale of the y-axis (click the image to see it in
full-size), but the decline was much less than 12%. Over the period, a
$10,000 initial investment fell to $9,885 (a decline of just 1.15%). At
the worst point (the end of July 2003), the value was $9,454 (a decline
of 5.46%).

There are two important takeaways here.

First, if interest rates rise very suddenly, a bond fund could
indeed experience a sharp decline (depending on its duration). However,
if interest rates rise very gradually over a period of a few years, the
fund’s performance is likely to be simply flat — or just slightly
negative or positive.

Second, if you hold the fund long enough (specifically, for a period
of time longer than the fund’s duration), a rise in rates works out to
your advantage because your reinvested dividends will be buying
higher-yielding bonds. (And if you’re in the accumulation stage such
that you’re regularly putting more money into the fund, your break-even
point will come even sooner.)

In other words, an increasing rate scenario isn’t necessarily a
catastrophe for bond investors. It depends how quickly rates rise, how
far they rise, what the duration of your holdings is, and how long you
will be holding them.