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What Happens to Bond Funds When Rates Go Up?

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.

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Comments

  1. garland whizzer says:

    Nice example showing the effects of a slow rise in interest rates on bond fund returns which remained close to 0 in nominal dollars over the time period in the face of rising rates. One question to consider, however, is how much a zero return in nominal dollars lost during that time period in terms of real, inflation-adjusted dollars, i.e. real purchasing power. In an environment of persistent inflation starting from a point of artificially low interest rates like we have now, bond returns in real dollars can remain negative for a decade or more, i.e. English bonds after WW2, where it took investors more than a decade to get back to zero in real purchasing power. Our current situation is artificially low rates created by the FED coupled with low inflation created by the financial collapse, but at some point in the future (no one knows when) inflation is likely to heat up and the longest and greatest bull market in bonds in bonds, the current situation, might transform into the longest and greatest bear market in bond history, a possibility that bond dominated portfolios should be aware of.

  2. GREAT article Mike. Thanks for the perspective!
    Happy trails, Mike

  3. Bill Combs says:

    I have 40% of my portfolio in bonds. That is broken down into 50% Intermediate Treasury; 30% Short term treasury; and 20% TIPS. What I would interested in knowing is if there is historical evidence that are current economic situation (extremely low rates, huge government debt, etc) is unique, and, if so, are we more than likely (I realize predictions are usually wrong) to see the long-term bull market in bonds that the first person mentioned? I realize that people have been predicting that rates would rise for the last couple years, but I think most everyone believes it will come sometime. I suppose if it is a slow rise my current bond allocation should not be too bad. What I am wondering is if the historical evidence points to our current situation as being unique such that I should modify my bond assent allocation for the inevitable? I suppose that might be more TIPS and Short-Term bonds.

  4. I’ve moved most of my bonds into cash. Nobody can predict when and how much interest rates will rise, although there is unanimous consent that they have to increase. I’ve seen the analyses showing that if you reinvest your dividends, bonds are OK over a 10 year period. I live off of dividends, interest, and capital gains, so it doesn’t make sense to take on interest rate risk when I can protect the former bond allocation and cash and limit my losses to the 1.5% erosion caused by the difference between interest rates and inflation.

    Shortening bond durations down from 5% to the 2% duration of short term bond funds is another way to minimize portfolio losses when the inevitable increase in rates comes. The problem is nobody knows when it will happen.

  5. Bill,

    Unfortunately, I don’t have the data you’re looking for. (Though frankly, even if I did have it, I would have roughly zero faith in its usefulness for predicting what will happen in our particular situation.)

    Perhaps somebody at the Bogleheads investing forum would have some such information.

    Edited to add: The Treasury itself provides information about historical yields. So from there you could at least determine what periods had sufficiently-similar yields to be of interest.

  6. Howdy,
    This isnt EXACTLY what you might be asking for. However, I posted the question “When interest rates rise, Total Bond Market Index vs Intermediate Treasury-Would there be any reason to expect that when interest rates rise the Vanguard Total Bond Market Index fund admiral shares might have a higher total return vs the Vanguard Intermediate Term Treasury Investor shares fund for say a 10 year time frame?”

    Of course I got some thoughtful responses. They might interest you. You can read them here: http://www.bogleheads.org/forum/viewtopic.php?f=10&t=109100

    Hey Mike can your blog be enabled to display the acceptable html to enter into post comments? Or do you have it posted somewhere on this site?
    Happy trails, cowboy Mike

  7. For simplicity, call the 21-month period two years. After two years, the investments in the fund was down 1.15%. Keep in mind the investor also used up 100% of the interest received during those two years to fill the NAV hole. That still wasn’t enough. Had the rate increase all happened at the beginning, you would get a -12% shock but then you would start getting 4.5% interest. After two years, you are down 3-4%. Down 1.15% over two years isn’t that much different than down 3-4% except it didn’t have a shock.

  8. Mike,

    Regarding HTML for the comments, any plain old HTML should be fine (e.g., em for italics, strong for bold).

  9. Well It is almost comical people who invest heavily in stocks worry what happens to bonds when interest rates go up. We know bond prices go down but the monthly cash flow remains about the same also when rates go higher it is a great time to buy more bonds I like high yield and corporate long bond funds because I like to get paid for taking some risk on my conservatively run Vanguard Funds. When the interest rates rise what happens to corporate stocks?? Well stocks will get crushed as high rates slow the economy and corporations are forced to pay a lot more for capital. Stocks are really like a 50-100 year Junk bond that pays a puny 2% dividend with 100% risk to capital. Companies are free to unilaterally lower dividends, issue more stock or borrow at will.

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