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Are Rising Rates a Reason to Shun All Bond Funds?

Rising rates affect various bond fund strategies differently. 

Cara Esser, 08/23/2013

With all the talk of rising interest rates, bond bubbles, and a great rotation into stocks, investors may think it's time to jump ship on all bond funds. However, various sectors of the bond market react differently during periods of rising rates. What's more, while history can be a guide, the economic environment as rates rise is always unique. There have been three distinct periods of rising 10-year Treasury rates in the past 20 years (1994 to 1995, mid-1999 to mid-2000, and mid-2004 to mid-2006), and the macroeconomic environment was not the same during each of the periods. What's more, none of those periods is highly representative of the current economic environment. An important consideration is the historically low level of rates from which the Fed will begin its tightening this time. Even as rates begin to rise, they will remain at low absolute levels for some time. And, investors' hunger for income isn't going away.

Of course, as interest rates rise, bond prices fall--this is a mathematical relationship from which many investors have been fleeing. But, certain sectors of the bond market react differently to rising rates. For example, more-credit-sensitive bonds, like high-yield corporates, tend to react less negatively to rising rates than do bonds with more interest-rate risk, such as a U.S. Treasuries. Additionally, investors need to consider total return, particularly in a low-interest-rate environment. While the price of a bond will fall, the income generated from coupon payments will not change on an absolute dollar basis. If a bond is held to maturity, unless it was purchased above par, the total return will include coupon payments plus the difference between purchase price and par. Price movements in the interim are simply losses or gains on paper. Writing off the bond market as a whole due to fears of rising interest rates is unwise because the potential for positive total returns (and regular income payments) exists.

Different Markets, Different Outcomes
To show just how differently certain sectors of the bond market have reacted to past rate increases, we looked at the three periods of rate hikes mentioned previously. Table 1 below lists total returns for those periods (total return include interest and capital appreciation or depreciation). The S&P 500 Index is also included for comparison to the overall equity market.

During the 1994 to 1995 rate hike (10-year Treasury rates rose to 6.0% from 3.0%), the worst-performing sector was investment-grade corporates. These bonds are subject to greater interest rate risk than credit risk, though Treasuries are a pure play on interest rates and the expectation would be for these bonds to suffer more. High-yield bonds did relatively well (these bonds are more sensitive to credit risk) because the overall economy was growing and corporations were profitable. In fact, during 1994, the stocks in the S&P 500 Index posted an earnings yield of 6.9% and a dividend yield of 2.9%, ratios that would decline steadily for the next 10 years.

The rate hike of mid-1999 to mid-2000 (10-year Treasuries rose to 6.5% from 4.75%) included the bursting of the Internet bubble, hurting credit sensitive investments such as high-yield bonds. Not surprisingly, the leveraged loan index, which tracks floating-rate loans made to below-investment-grade firms, did quite well, despite the concerns over defaults in the technology sector. Floating-rate loans have virtually no interest-rate risk because as rates rise, loan payments are reset based on current short-term rates. With inflation at historically low levels at the start of 1999 and rising through much of 2000, investors also found solace in inflation-protected securities like Treasury Inflation-Protected Securities, the strongest-performing index on the list.

The largest rate hike in recent history happened between June 2004 and June 2006, when rates were pushed higher 17 times for a total increase of 425 basis points (to 5.25% from 1.0%). During these two years the economy was humming along (though headed for disaster) and bonds and equities produced positive total returns, with high-yield bonds outpacing the S&P 500 Index marginally.

While the last column in the table is not related to an actual rise in rates, the Fed's taper talk disrupted the fixed-income market toward the end of May and into June of this year. Despite no actual change in long-term rates, many investors took this news poorly, fleeing with little regard to the subtle differences in bond types. Even the Leveraged Loan Index, essentially free of interest-rate risk, lost ground during June. After the initial shock wore off, some sectors bounced back, though most finished the three-month period lower.

Where to Go From Here
Looking at the table above and assessing the current environment, investors may be more interested in floating-rate funds. After all, there is little to no interest-rate risk and, assuming the economy keeps improving, default risk should remain low. But it's important to note that fund flows into floating-rate mutual funds and exchange-traded funds have been enormous over the past year. In the closed-end fund, or CEF, universe, many of these funds are selling at premiums, though bargains can still be found.

Cara Esser is a closed-end fund analyst at Morningstar.

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