Time To Review Your Bond Funds
Last month, the Federal Reserve boosted the discount rate, the rate it charges banks to borrow, by a quarter of a percentage point. Fed Chairman Ben Bernanke stressed that the move did not signal a near-term increase in short-term interest rates. Still, it appears that the Federal Reserve is laying the groundwork for interest-rate hikes — maybe even later this year.
Historically, Fed rate hikes have hurt bond-market returns. When the Fed raises the federal funds rate, the overnight cost of money in the banking system, interest rates on bonds of all maturities typically rise. Interest-rate risk relates to how bond prices often fall when interest rates rise.
Still, Fed actions have had mixed results on bond prices. Consider 1999, when the federal funds rate rose three-quarters of a percentage point to 5.5%. That year, the Barclays Capital U.S. Aggregate Bond Index fell 0.8% — its only negative return over the last 15 years. The following year, the federal funds rate rose a full percentage point to 6.5%. Yet the aggregate bond index rose 11.6%, marking its second-best showing since 1995.
While interest-rate risk worries many investors, other factors also affect bond performance.
Rising inflation erodes the value of a bond’s principal and interest payments, influencing investor demand.
Credit risk reflects the chance that a company might not make principal or interest payments on its debt. Following the financial meltdown of 2008, investors flocked to government bonds to mitigate credit risk.
Bond prices are linked to the economy, where an uptick in economic growth could stoke inflation and spur the Fed to raise rates.
In our view, investors should not abandon bond funds or make drastic changes to their portfolios. And even if rates trend higher, long-term investors may benefit by reinvesting their interest income at higher yields. Still, bond investors should keep the following points in mind:
• Funds that hold shorter-term bonds have an advantage when rates climb. A bond’s interest-rate risk increases with time to maturity — short-term bonds are less sensitive than long-term bonds to changes in rates. Duration estimates the percentage change in a fund’s share price in response to a one-percentage-point change in rates. Duration can be found at www.morningstar.com, the Web site of Morningstar, a provider of mutual-fund data.
• Look for low fund expense ratios. High expense ratios drag on performance, especially when yields are low. The average intermediate-term bond fund charges about 1% annually.
• Corporate bonds remain attractive even though spreads between yields on corporate bonds and Treasury bonds have shrunk significantly from a year ago. Corporate bonds have benefited from a healthier economy and improved balance sheets and cash flow. For most investors, funds holding short-term and investment-grade corporate bonds are good choices.
• Most investors in U.S. government bonds should also focus on short- and intermediate-term funds, as funds holding long-term bonds face the most interest-rate risk. Over the last three months, the average long-term government bond fund has tumbled 2.4%, versus a gain of 0.5% for intermediate-term governments.
• Treasury inflation-protected securities (TIPS) are potential laggards if expectations for inflation remain tame. So far this year, funds holding TIPS have returned an average of 0.50% — the worst showing among the 29 bond categories tracked by Morningstar. The value of TIPS are adjusted based on the consumer price index, which is expected to rise about 2.2% this year, in line with recent increases. Should rates rise and inflation fears reignite, higher inflation adjustments may offset price declines.