Bond Funds If Rates Rise

It's a well-told story by now—investors have been adding money at record rates into bond mutual funds over the past several years. One side of this story is that risk-aversion has driven investors into bond mutual funds. However, it's also possible—we think likely—that some investors are motivated by a desire to generate income, especially as they age. No matter what the motivation behind the fund flows, is it possible to estimate the possible impact to different types of bond funds if and when rates rise?

There is no single bond market, or a single interest rate. The global bond markets are larger and more diverse than global public equity markets, and each market has different motivations from different types of investors. If rates rise, the impact on different types of bonds and types of bond funds will vary in magnitude, we believe—though it is important to note, as most investors know, that rising rates will likely have some negative impact on the price of most bond funds.

One useful feature of bonds is that they have a fixed time horizon. Equities, for all their value and worth as long-term investments with potential to grow, do not have fixed maturities or time horizon for investments. This is why an appropriate balance of stocks and bonds in a portfolio still makes sense to us, based on your time horizon and risk tolerance. Bond funds do not have a fixed maturity date. But investors can choose funds that target certain maturities. The bond fund doesn't mature, but the bonds held within the fund have greater or lesser interest rate risk depending on their average maturity.

Invest in bond funds based on your time horizon. When might you need to spend your principal? That's a good rule of thumb when thinking about an investment in bond funds. For money that's needed very soon, we suggest sticking with cash investments or checking or savings accounts where the risk from interest rates is lowest. For money needed within the next 1-3 years, focus on short-term bond funds. These funds hold shorter-maturity bonds and are generally less volatile in a rising rate environment. The fund mangers can also take advantage of higher rates more quickly with less impact than managers in intermediate-or-long-term funds. For an investment where principal may be needed within 3 years or more, consider intermediate-term bond funds.

Most of the return from bonds has come from income over time. It may also be helpful to remember that the majority of the returns from bonds over time have been from interest payments, not changes in prices. Rising rates will ultimately help income-oriented investors, in our view, if they can focus on their time horizons and the combination of income and price-driven return.

Bottom line. For individual investors, we think it'll pay to keep the risk of rising interest rates in mind, but don't let it derail your plans for a sensible allocation to bonds or bond funds. We suggest looking at the risk in the funds you own and make sure they fit your risk tolerance and time horizon.

Source:  Charles Schwab

The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.

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