Short-Term Bonds Seeing Biggest Impact From Rising Rates

Christine Benz:

Hi, I'm Christine Benz for Morningstar.com. What are the implications of rising bond yields for bond mutual funds? Joining me to discuss that topic is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel:

Glad to be here.

Benz:

Russ, this is something that appeared in the latest issue of

Morningstar FundInvestor,

where you and the team looked at what's been going on with bond fund yields. But before we get into that, let's discuss how investors should navigate some of these yield statistics that they see. We've got 12-month yield on the site as well as SEC yield. Which of these numbers should they be paying attention to?

Kinnel:

Maybe the SEC yields. The SEC yield is a 30-day yield; the 12-month field tells you what the fund distributed over the trailing 12 months. When interest rates change a lot, the 30-day is going to be a better guide. It's got its own quirks, but it's at least going to reflect the current market a little better than the 12-month yield.

Benz: The SEC yield is sort of a near-term snapshot?

Kinnel: That's right.

Benz: And that's an annualized figure?

Kinnel: Yes.

Benz: Let's talk about, as yields have come up over the past couple of years, let's talk about some of the categories that have experienced the biggest increases in their yields, because they are pretty meaningful.

Kinnel: Somewhat surprisingly, it's the short end of the curve that's gone up the most. We are seeing the yields have really grown in short-term Treasury funds, short-term bond funds, and some others, intermediate funds as well. It's really the short end, the area we've kind of all tuned out recently because there wasn't any yield. Who really cared about short-term bond funds or ultrashort funds or money market, there was no yield. Now, there is yield.

Benz: The intermediate and longer-term funds haven't participated as much. I know that there are a lot of moving parts that affect bond yields. But what do you think is going on there?

Kinnel: It often happens when you see the market start to think that inflation is rising, and there might be recession looming out there that the gap between the short end and the long term declines. So we are getting a flattening of the yield curve. It hasn't quite inverted yet as we are speaking but it's not too far off.

Benz: In terms of the yield increases that we have seen on some of these products, you referenced that short-term bond funds have seen a nice pop up in their yields. What are we talking about?

Kinnel: If you look versus a couple of years ago when short-term bond fund yields were somewhere between 50 and 100 basis points, now they're mostly between 200 and 250 basis points, so a significant pop. Of course, that means you've also got some modest losses in there, because that's what happens when bonds adjust is they sell off to produce that higher yield. You'd have some modest losses, only about 100 basis points for the most part, but a pretty significant hike in yield.

Benz: Your point is that for investors who had just been saying, I'm going to hunker down in cash, I'm not really getting paid to take bond risk--today maybe you are?

Kinnel: For sure. And I think people went both ways. Really, they went into cash, but they also went into longer-term bond funds and into high-yields because they actually had yield. Now these gradations are back, in that short-term bond funds are worth looking at again because they do have meaningful yields and there's some logical place in your plan for a short-term bond fund.

Benz: You might have, though, some near-term losses as investors in these funds have experienced very recently. How should investors think about that? Should they kind of use their time horizon to guide what sort of product they are in?

Kinnel: Most definitely. You see these short-term bond funds took like a 1% loss, and that's usually about the worst they do unless they are taking some big credit risk or something. Obviously, that gives you some idea of how to use them that they're not your first line of defense. If you've got kids' tuition coming in a couple of months or something, that should be in something like a money market, a bank savings account, something where you don't have to worry about the principle going out, but then it can be right after that, as your next line of defense. A short-term bond fund shouldn't lose very much, especially if you have, say, a short-term Treasury fund. And then after that would be intermediate funds and others that have some more risk and could lose a more meaningful amount.

Benz: Russ, great to get your insights. Thank you so much for being here.

Kinnel: You're welcome.

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