Now that Fed tightening appears imminent, investors are wise to take a close look at the fixed income portion of their portfolio, especially if it consists of bond funds.
The reason I am picking on bond funds here is that they carry greater market risk than other fixed-income investment types, such as individual bonds.
Bond prices generally move in the opposite direction as interest rates. Therefore, when rates are rising, prices are falling and bond fund investors are fully exposed to the possibility of falling prices, whereas the investors in individual bonds can hold their bonds to maturity, receive interest and receive their full principal back at maturity, assuming the issuing entity does not default.
In other words, get ready for falling prices for bond funds, especially those that are most sensitive to interest rates. So let’s be sure we don’t have any bond fund types that are almost certain to lose big money when the Fed starts raising rates.
Avoid Bond Funds With the Greatest Interest Rate Sensitivity
Generally, in a rising interest rate environment, investors will want to avoid investments with the highest interest rate sensitivity, which is a measure of how much the price is expected to fluctuate as a result of changes in interest rates.
So as the market expectations for a tightening Fed become greater, and when the rates actually begin rising, bond funds that are more sensitive are likely to have greater price declines than those with less sensitivity.
Here are three types of bond funds that tend to decline in price more than other types of bond funds in a rising interest rate environment.
Long-term Bond Funds: The longer the maturity, the greater the sensitivity. Therefore, when interest rates go up, long-term bond mutual funds and ETFs will fall in price faster than intermediate- and short-term bond funds. For example, the most recent calendar year where bond prices fell was 2013, when the Barclays Aggregate Bond Index fell -2.02%, whereas a typical long-term bond fund like Vanguard Long-term Bond Index (MUTF:VBLTX) fell -9.13%. However, in the following year, when the Fed delayed their credit tightening, bond prices got some relief and went back up. The index was up 5.9% and VBLTX was up 19.7%.
Zero-Coupon Bond Funds: These are a sub-category of U.S. Treasury bonds which get their name because they pay no interest and the par value is due the investor at maturity. This makes even their price sensitive to interest rates. Therefore, zero-coupon bond funds, especially the long-term variety, are among the most interest rate-sensitive security types. For an example of this sensitivity, look no further than PIMCO 25+ Year Zero Coupon US Treasury (NYSEARCA:ZROZ), which dropped more than 20% in 2013 but then returned in 2014 with a staggering 48% price gain. Now that’s sensitive!
High-Yield Bond Funds: Junk bonds tend to follow long-term interest rates, and rising interest rates can worsen yields, which is the primary reason investors buy these funds. This translates into a recipe for falling prices in a rising interest rate environment. Furthermore, some high-yield investors may also turn away from these funds if recession is feared to be around the corner because of increased default risk in a poor economy. For example, in the depths of the last recession, in 2008, one of the best high-yield bond fund you can buy, Loomis Sayles High Income Opps (MUTF:LSIOX), took a stock-like dive of -25.4%, whereas the Barclays Aggregate managed a 5.24% gain.
To summarize, let’s simply review Warren Buffett’s profound investment advice: “Rule #1: Never lose money. Rule #2: Never forget rule #1.”
When dealing with bond funds that are sensitive to interest rates, you may want to take a close look at Rule #2.
As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.