Since March of 2020, The Federal Reserve has kept the Fed Funds target rate at the 0-0.25% range to stimulate the economy, and elected to maintain that level at the most recent Federal Open Market Committee meeting. With the country beginning to reopen and return to normal, the idea of rising interest rates has resurfaced.
While the Fed continues to watch economic data to determine the target rate, long-term rates are still controlled by investor demand. Yields on the 10-year Treasury bond have inched up this year evoking an important aspect of investing in bond funds, understanding interest rate risk.
A common misconception of investing in bonds is that when interest rates rise, bonds fall out of favor as their prices drop. While the inverse relationship between interest rates and bond prices exists, there are many factors to consider when planning current and future bond holdings – whether to hold individual bonds or invest in a bond mutual fund.
A bond fund’s duration, specifically modified duration, is an indicator of how sensitive the net asset value is to a change in interest rates. Duration provides investors with another aspect of comparison between bonds with different maturities and coupon rates. Simply stated, for every 1% change in interest rates, positive or negative, the price of a bond fund will inversely decline or increase by its modified duration. For example, if a fund’s modified duration is 5 years, the net asset value could be expected to rise 5% for every 1% decline in interest rates and fall by 5% for every 1% increase in interest rates. Bond funds with longer average maturities and lower average coupons have a longer duration, and therefore generally experience a higher degree of price fluctuation, while bond funds with shorter average maturities and higher average coupons have a shorter duration and generally experience a lesser degree of price fluctuation.
Price Returns and Total Returns
The good news is that performance of bond funds is not solely tied to the incremental changes in interest rates. Bond fund total returns are generated from two sources; interest payments on bonds (paid as fund distributions) and changes in bond prices. While interest rates rise, active portfolio managers have opportunities to purchase bonds at higher yields, and over time, a portfolio’s income may offset a decline in the value of individual bonds, mitigating the impact of that decline on a Fund’s total return.
Since its inception in 1980, approximately 98.6% of the Bloomberg Barclays Municipal Bond Index total return has been generated by income.
Active Bond Fund Management
Periods of rising rates can be challenging for investors who purchase individual bonds or funds aligned with a bond index. Active bond fund managers have the ability to take strategic steps to mitigate, to some degree, the impact of market volatility. With the ability to actively manage fund holdings over time, these managers may implement a number of strategies to adjust fund holdings based on market expectations. Fund holdings may be altered by quality rating in an effort to manage credit risk – a risk that may increase along with rising rates. Holdings may also be altered by maturity date and coupon, thereby adjusting portfolio duration or the sensitivity of the portfolio to movements in rates. Reducing portfolio duration would reduce sensitivity to a change in rates.