How Different Types of Bond Funds Respond to Rate Hikes

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Many market-watchers believe that the Federal Reserve is set to raise rates in mid-December 2015. Joining me to discuss the likely impact on bond fund portfolios is Cara Esser, she's a senior analyst at Morningstar. Cara, thank you so much for being here.

Cara Esser: Thanks for having me.

Benz: Before we get into the specifics of the impact of rising rates on various types of bond portfolios, let's just do a little bit of stage-setting. You say that it's really important to remember that the Federal Reserve is only controlling the short end of the yield curve. Let's discuss first what the yield curve is, and also why the Fed's tools only apply to the short end of the curve.

Esser: So when most people talk about "the yield curve," what they're talking about is the Treasury yield curve. Though of course, you can have yield curves for all different types of bonds, and all different credit qualities. In terms of the Treasury yield curve, what we're looking at is a plot of varying yields, typically from three months to 30 years, of different Treasury bonds. You'll typically see that the yield curve is upward-sloping, so the long-term end of the yield curve is going to be yielding more than shorter-term Treasury bonds. But you can see yield curves of varying shapes, sometimes inverted, sometimes it's deeper, or flatter based on how the market is reacting to certain things.

The Federal Reserve has the ability to somewhat control the short end of the yield curve by raising and lowering short-end interest rates and that is by raising and lowering the rate at which banks lend to each other. The question here is, what happens to the long-term bonds on the yield curve, the long end of the yield curve? And what happens is, it depends. It depends how the market essentially reacts to the Fed moving interest rates.

Benz: Okay. So if I hold a longer-dated bond, it may not necessarily respond straightaway if the Fed begins raising interest rates?

Esser: That's exactly right. So the market will determine, is the Fed raising interest rates too fast, too slow, too soon, too late? And those things will manifest themselves on the longer end of the yield curve. And we've known that in different rate cycles, the yield curve will respond very differently based on certain economic factors and other things in the market. So, for example, when we looked at the rate hikes of 1994, we saw that the yield curve shifted in a more or less parallel fashion. So the long end moved up almost as much as the short end moved up. We found that in the rate hikes of 2004 to 2006, that the long end of the yield curve did not rise nearly as much as the short end, so we saw a flattening of the yield curve.

Benz: Okay. Let's take a look at some different bond fund types starting with government bonds. They're usually thought to be the most responsive when the Fed begins to take action. Is that the case in your view? 

Esser: That is the case. And again, it'll depend on the maturity, obviously, of the bond and the shape of the yield curve. So again, going back to if the yield curve moves in a more or less parallel fashion, so the long end is rising about the same as the short end, long-term government bonds are going to perform poorly because they have longer durations. If we see what we saw in 2004 to 2006, so the long end of the yield curve either maybe doesn't rise as much, maybe it falls, or it stays the same while the short end rises up, we see a flattening of the yield curve. Longer-term bonds are going to do better than they would under the parallel-shift scenario.

Benz: Okay. What about more credit sensitive bond types? I think a lot of investors are operating with the assumption that they will behave better than a period in which the Fed is raising rates.

Esser: Yes, and that's typically right. So what we need to pay attention to is how is the economy doing? If interest rates are rising and the economy is doing well, we tend to see that credit-sensitive bonds, or junk bonds, tend to perform fairly well. And that's because if the economy is doing well, the companies themselves are probably doing well. On the other hand, depending on how quickly or how high interest rates rise, it depends... It changes the cost of borrowing for the company. So that, if the cost of borrowing goes up tremendously, that will have an impact, probably a negative impact on the long-term financial health of all of these credit companies.

Benz: How about bank loans? They're kind of a separate case this time around, you say.

Esser: Yes. A lot of people look to bank loans in periods of rising rates, and that's because bank loans pay a coupon that is floating based on a short-term interest rate. So mostly, it's three-month LIBOR plus some sort of interest-rate spread. So generally, you would think if short-term interest rates go up, the coupons and the bank loans will also rise. So they don't have that interest-rate sensitivity. The problem that we have this time around is that to entice people to purchase bank loan funds after the 2008 market crash, many companies put what is called a "LIBOR floor" onto the bonds that the issued, and so that basically said a minimum amount of payment that they will make to the bondholders, regardless of how low LIBOR actually fell. So right now, the average LIBOR floor is much higher than three-month LIBOR. So if three-month LIBOR for example, goes up, it has to go up quite a bit to breach that floor. So we won't actually see coupons changing for most of the floating-rate bonds until interest rates rise fairly significantly.

Benz: How about the core intermediate-term funds that a lot of investors tend to own? They're not all government bonds, but they certainly don't own much in the way of junk bonds either.

Esser: Yeah. So here it depends on what exactly your fund is doing. There's a range of strategies that fall into this category. Some are more credit-focused, some are more government-focused. So if your fund is overweight credit, you can expect it to probably hold up better than a fund that might be holding more government bonds. So what you really need to understand is what's going on underneath the hood of your fund. The more "Agg-like" it is, for example, the more Treasuries it has, the more mortgage-backed securities it has, the fewer corporates it has, it's probably not going to perform all that well in a period of rising rates.

Benz: So when you say "Agg-like," you mean in line with the Barclays Aggregate Bond Index?

Esser: Correct. So mostly government-backed bonds, a lot of Treasuries, very few corporates, very low credit risk in those types of funds.

Benz: Okay. But more interest-rate sensitivity, potentially? 

Esser: Correct. 

Benz: Okay. Now, we've been talking mainly about U.S. bonds, how about foreign bonds? I would imagine it's difficult to predict how they'll respond to a rising-rate environment here in the U.S.

Esser: It's very difficult to predict and there are a lot of moving parts here when you look into global bonds or emerging markets, and one is country risk. While we're doing pretty well in the United States in terms of economic growth, there are a lot of countries that are not doing as well. Some are in recession, some are not growing as quickly as we are are here. So, you have to take into account what's the global economic picture, what does it look like in each of those countries? And then you also have the currency risk, which is a wild card. So, is the currency appreciating or depreciating versus the US dollar? And all of that is going to play into the total return of the bond.

Benz: So, I guess another thing to keep in mind, too, is that the bond market isn't waiting around for the Fed to act, that it's already pricing in some of these things that various bond market participants think might happen. I would imagine that some of these effects are already, more or less, priced into the bond market?

Esser: Yes, that's exactly right. We've seen the short end of the yield curve actually move slightly up in these last few months as the Fed has been inching closer and closer to actually raising the short-term interest rate. So, while they do control, if you will, the short end of the yield curve, they don't have total control over the short end of the yield curve. The market is still moving on its own accord as well.

Benz: Okay, Cara. Thank you so much for being here to explain all of this to us.

Esser: Thank you so much for having me.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.