How Will Bond Funds React to Rising Rates?

Fixed-income investors continue to fret about the potential timing and magnitude of future rate hikes from the Federal Reserve. Coming into 2015, the general consensus was that the tightening cycle would begin in June, but after a round of economic data that was slightly weaker than anticipated, expectations shifted to a later rate hike. At its meeting last week, the Fed decided to keep rates unchanged, although it signaled a likely hike later in the year.

As my colleague Eric Jacobson noted in his recent article on the potential impact of a Federal Reserve rate hike, it's difficult to predict how the yield curve will move once the Fed acts. That said, we have some ideas about how different Morningstar Categories are likely to react to an increase in interest rates.

Investment-Grade Taxable-Bond and Municipal-Bond Funds Morningstar breaks investment-grade bond funds into categories based on each fund's interest-rate sensitivity, as measured by their reported duration. In general, funds in the ultrashort bond Morningstar Category are the least sensitive to changes in bond yields, while funds in the long-term bond and long-term government bond categories are the most interest-rate sensitive. (A similar dynamic is at play in the municipal-bond categories.)

That said, the Federal Reserve doesn't control the intermediate- and long-ends of the yield curve, and markets have responded very differently in past rounds of rate hikes. For example, during the rate hikes from March 2004 to June 2006, yields on the 30-year bond actually fell as the yield curve flattened; during the September 1993 to December 1994 hikes, yields rose across the yield curve. If the yield curve steepens (the long-end rises faster than the short-end) or shifts upward in a more or less parallel fashion, long-term bond funds could take a significant hit. But if the yield curve flattens, which is not out of the question given the troubles abroad that may continue to push investors toward the safe haven of U.S. Treasury bonds of all maturities, longer-term funds may fare better. For example, during the 2004-06 rate hikes, the 10-year Treasury bond lost 1.7% while the 30-year bond gained 2.2%.

Corporate-Credit Bond Funds If the U.S. economy remains relatively healthy, credit-sensitive funds could perform better than funds that hold more-rate-sensitive bonds, like higher-quality or longer-maturity Treasury bonds if long-term bond yields increase. A strong economy is likely to be good for corporate issuers, which could help push corporate-credit spreads tighter, benefiting funds in the high-yield bond and bank-loan Morningstar Categories.

Bank-loan funds have drawn particular attention from those concerned about rising bond yields, thanks to the floating yields offered by bank loans. Indeed, in 2013, when long rates rose against the backdrop of the so-called taper tantrum, bank-loan funds saw a surge in inflows. But the prevalence of Libor floors means that coupons on many bank loans are not likely to rise with the Fed's first rate hikes. Morningstar strategist John Gabriel discussed Libor floors in May 2015 and noted that at the end of 2014 the weighted average Libor floor on the S&P/LSTA U.S. Leveraged Loan 100 Index was 0.85%. This essentially creates a fixed coupon on a floating-rate security until Libor exceeds many bank loans' Libor floors and introduces some, albeit limited, rate risk to bank-loan funds.

For high-yield corporate bonds, rate sensitivity within the category is likely to vary. While underlying fundamentals and defaults ultimately drive returns for high-yield bonds, they do face some interest-rate exposure. Funds that focus on BB rated bonds, which are at the high end of the high-yield credit spectrum, are the most sensitive to increases in longer-term bond yields. While many expect high-yield bonds to fare relatively well if long-term bond yields increase, it's possible that they won't do as well as expected. The Fed's zero interest-rate policy has pushed investors further out on the risk spectrum, and many core bond funds now carry healthy doses of high-yield bonds. And the increasing illiquidity in the high-yield market is making it more and more difficult for fund managers to sell securities in the face of outflows.

Global-Bond Funds While the U.S. economy seems to have turned the corner, the story abroad is murkier. Generally, it's expected that the eurozone and Japan (the two main non-U.S. developed markets for bond investors) will be relying on quantitative easing much longer than the United States, thus delaying their own rate hikes. But the market for high-quality non-U.S. government bonds, including German bunds and Japanese government bonds, can track U.S. Treasuries when investors seek safe-haven assets. If the Fed continues to delay the rate hike, it could be seen as a signal that it's concerned about economic growth and may stoke fears of slowing global growth, and German and Japanese government bonds could strengthen. Under the same scenario, the dollar is likely to weaken, which would boost issues denominated in euros or yen.

Turning to the emerging world, investors are already nervous about what a U.S. rate hike may do to emerging-markets bonds. That's because emerging-markets countries with large amounts of dollar-denominated debt are already facing a more expensive debt load as their currencies have weakened against the dollar. Continued uncertainty about the timing of a Fed rate hike, or a rate hike itself, could cause more damage to the asset class as nervous investors continue to flee. Under that scenario, local-currency emerging-markets bonds, which have already been hit harder than issues denominated in U.S. dollars, are likely to suffer more as investors dump the riskier fare.

What does this mean for an investor's portfolio? Predicting the timing and magnitude of interest-rate movements is a difficult task, and many bond portfolio managers believe it's folly to significantly change a fund's duration based on interest-rate predictions. Investors are better off sticking with an allocation that suits their long-term investment goals, and understanding how different bond funds might perform during various rate environments can help.