Don’t Dump Bond Funds Because of Rising Rates

When rates rise, bond prices fall, but as much as this is like the law of gravity for the debt market, it doesn’t necessarily follow that bond funds have to get crushed when the Federal Reserve finally hikes short-term interest rates.

Corporate Bonds bond fundsTrue, the Fed hasn’t increased rates in almost a decade, so it’s understandable if fixed-income investors can’t remember what their bond funds did the last time we went through a rate-tightening cycle.

But, a quick look back at history shows that the risks of holding bond funds when rates rise are quite manageable. Indeed, some categories of bond funds have done very well when the Fed has lifted rates in the past.

Analysts at Charles Schwab examined how different categories of bonds fared during the last three rate-tightening cycles, and the results were well short of a wipe out. True, volatility picks up, especially early in the cycle, and negative returns are a very real risk.

Losses were not, however, a foregone conclusion. In fact, four main categories of bond funds — short term, intermediate term, long term and multi-sector — collectively generated positive cumulative returns far more often than negative ones through the last three cycles.

Heck, even long-term bonds — which are the most at-risk when the Fed hikes rates — managed to generate strong, positive returns through the last tightening cycle.

As every investor in bond funds should know, short-term bonds are less sensitive to interest rates than longer-term bonds. That’s why something like the Vanguard Short-Term Bond Fund (VBISX) or Vanguard Short-Term Bond ETF (BSV) should do better than, say, the Vanguard Long-Term Bond Fund (VBLTX) and Vanguard Long-Term Bond ETF (BLV) as rates go up.

Bond Funds Busted Out Last Time Around

But, that sure wasn’t the case the last time the Fed enacted a series of rate hikes. Have a look at this table from a report by Rob Williams, the director of income planning at the Schwab Center for Financial Research:

bond funds

Counterintuitively, long-term bonds greatly outperformed short- and intermediate-term bonds over the course of the previous 25-month cycle of tightening.

Long-term bonds generated returns of nearly 8%. Multi-sector bond funds, which can hold everything from foreign debt to junk bonds, did even better at 12%. Meanwhile, short-term bond funds came in last, with a cumulative return of 4%.

Critically, every bond category made it through the last cycle without suffering losses. Indeed, the hikes even helped, as most of a bond’s return comes from income, not price. As rates rise, bond fonds are able to add higher-yielding debt to their holdings.

In the cycle of 1999-2000, only long-term bonds had a negative return. Even then, the loss of 0.6% was hardly a disaster. Indeed, it’s been 20 years since bond funds were slammed across the board in a tightening cycle.

The most important point here is that bond funds held up well over the course of the entire cycle. Here’s a chart from Schwab showing performance through the last period of tightening:

bond funds

Rising rates hit bond funds pretty hard, at first. Volatility spiked, and decline prices more than offset contributions from income. But, they didn’t take long to recover and were soon putting up some enviable returns.

Given enough time, bond funds — short- and intermediate-term, in particular — should perform just fine amid the first rate hike in almost 10 years.  Score another win for patient investors.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

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