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CEF Specialist

Bond CEFs and Rising Rates

How will bond CEFs perform as the Fed raises rates?

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The inverse relationship between bond prices and interest rates is a central tenet of bond math. As rates rise, new, higher-coupon bonds become more attractive than previously issued lower-coupon bonds. To get investors to buy those lower-coupon bonds, prices must fall. Eventually higher bond yields will be good for investors, but the short-term pain hits investors where it hurts: with lower investment returns because of the drop in bond price. For bond closed-end funds, or CEFs, the pain of rising interest rates is exacerbated by the funds' use of leverage.

Experienced bond investors may look at a fund's duration (a measure of price sensitivity due to changes in interest rates) to determine whether a portfolio is "protected" from rising rates. Duration, however, has several shortcomings. It's a good measure of interest-rate risk for noncallable Treasury bonds but becomes less predictive for funds with more credit risk, such as junk bonds, or unpredictable cash flows, such as mortgage-backed securities. In addition, portfolio-duration measures assume a parallel shift in the yield curve. Simply put, they assume that all rates along the entire yield curve (one month to 30 years) move up or down by the exact same amount. However, this is almost never the case in the real world.

Cara Esser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.