With the U.S. Federal Reserve poised to start raising interest rates more aggressively this year, many people – including some investment advisers – have expressed concerns about investing in fixed-income mutual funds.
For those unfamiliar with bonds, the dilemma is that when rates rise, bond prices fall, and vice versa. The fear is that bond funds, which hold numerous bonds, risk losing value whenever the Fed increases rates.
The alternative – purchasing individual bonds – guarantees that the owner will receive the full value of the principal if held to maturity, unless the issuer goes bankrupt.
Individual bonds versus mutual funds
Will individual bonds (or a bond ladder) provide better returns than bond mutual funds when rates rise?
The answer is no. Here’s why: Recognize that there are two components to bond returns: capital gain or loss (that is, changes in price) and the interest earned on the bond. After a rate rise, if an individual bond is held to maturity, the bondholder will avoid the consequent price drop but will be giving up the higher income that he or she could have gotten by selling the bond and purchasing a higher-yielding bond.
Which has the greater impact on a bond’s return? In 2011, The Brandes Institute compared the returns from each of the two components for U.S. bonds over rolling five-year and 20-year periods going back to 1928. They found that across the average of all five-year periods, the interest returns represented nearly 90 percent of the total bond returns. For the 20-year periods, it was closer to 100 percent.
In other words, the impact of price declines for bonds held for more than five years over the past 85 years or so – which included one period of rising rates and two of declining rates – was minuscule compared to the interest generated by the bond investments. So buying and selling (which is what funds do) would have provided better returns than simply buying and holding.
Another factor to consider is that bond prices tend to increase as they move closer to their maturity date in most “normal” upward-sloping yield-curve environments. Therefore, after an interest rate rise (and consequent price drop), the price has further to rise as the bond matures and thus increases more rapidly for some period of time immediately afterward.
Actively managed bond fund managers understand this well and can time the sales of the older bonds to squeeze out additional returns while acquiring newer, longer-maturity bonds paying higher interest. This process, known as “rolling down the curve,” is practiced by many active bond fund managers. By contrast, if you hold bonds to maturity, you lose the ability to take advantage of this and other techniques for generating additional returns.
What if an individual bond investor chose instead to create a bond ladder – the purchase over time of a series of bonds with overlapping maturities – to avoid remaining stuck with low-interest bonds after rates rise?
Unfortunately, in today’s low-yield environment, such an investor would be locking in returns at below-inflation yields for at least the next few years (or even longer depending on the bonds’ maturities).
The only way to generate above-inflation yields right now is by investing in corporate or other higher-yielding types of bonds. Unfortunately, that would involve increasing credit risk and reducing the return certainty that owning individual bonds was intended to provide in the first place. In addition, purchases of bonds other than Treasuries in small quantities incur significantly higher trading costs, further suppressing the returns for an individual bond purchaser.
I can find no evidence to suggest that owning individual bonds provides better returns over time compared with owning actively managed bond funds, even during rising rate environments.
Fixed-income investors can still protect against rising rates using funds, for example, by keeping durations low or by diversifying the types of bonds. There’s no need to fear rising interest rates or their impact on fixed-income mutual funds unless you need to liquidate the investment in the short term (in which case the fund still would be superior to the less liquid bond).