Chart of the day, bond-fund edition

By Felix Salmon
August 21, 2013

Josh Brown reports today that according to a recent survey by Edward Jones, 63% of Americans don’t know how rising interest rates will impact investment portfolios, adding that “they’re learning the hard way right now, it would appear”.

The fact is, however, that pretty much nobody understands the connection between rising interest rates and asset prices. In fact, even the relationship between rising interest rates and bond fund prices is pretty opaque. Sure, we all know that in the world of fixed income, when yields go up, as they have of late, then prices go down. But how much do prices go down? If I tell you that the yield on the 10-year Treasury bond has gone from 1.8% to 2.8% in recent weeks, can you tell me what has happened to its price? You can’t say, since you need to know the coupon as well. For instance: with a 2% coupon, a 10-year bond seeing such a move would lose 8.6% of its value, while with a 5% coupon, it would only lose 7.8%.

But more to the point, very few individual investors actually own the 10-year Treasury bond itself. Instead, when they want fixed-income exposure, they buy a bond fund, which is likely to include a wide variety of coupons, credits, and maturities. There are quite a few stock-pickers out there, but there are precious few bond-pickers: bond investing is hard, boring, laborious work, and just about all individual investors outsource it to someone else.

So, how are bond funds doing, during this torrid time for the fixed-income world? The chart above shows how various popular bond funds have performed over the past 10 years; the main line shows the fortunes of the $110 billion Vanguard Total Bond Market fund, an index fund which gives a pretty good impression of how  bond investors as a whole are doing. Its fortunes are more or less in line with those of the Fidelity Total Bond fund, the Fidelity Spartan US bond fund, and the Pimco Total Return fund. The Pimco Unconstrained bond fund — the light green line — has outperformed, while the Loomis Sayles bond fund — the light blue line — has done better still, albeit with much higher volatility.

All the bond funds have seen a bit of a dip in recent weeks, but it’s the kind of move they’ve seen many times in the past, and it’s not the kind of move which is likely to cause an individual investor to panic. The main thing you learn from looking at this chart, indeed, is not that we’re in the midst of a historic bond-market selloff, but rather just that bond funds in general are pretty good at doing what they’re meant to do — which is to broadly retain their value over time, and with any luck go up over the long term, with reasonably low volatility.

Now it’s true that over most of the period seen in the chart, rates were going down rather than up. But it’s not strictly true that if rates are going up then the value of your bond-fund holdings is certain to go down. And even if you hold an index fund, I can tell you with 99% certainty that you have no idea how much it might fall in value with any given rise in rates. Individual investors neither can nor should be expected to do complex modified-duration calculations on their fixed-income portfolios, let alone be able to add a credit-forecast overlay to such a thing.

The fact is that rising rates are, in general, a sign of improving economic fortunes — and that they might well coincide with tightening credit spreads and greater economic activity, including new corporate borrowing. Yes, they might also mean a reduction in bond prices, but that kind of cost is easy to bear if it means a return to normality and growth in the rest of the economy, including possibly in stock portfolios.

According to a recent Fannie Mae forecast, the quantity of new mortgage lending will go up by 21% in the second half of this year compared to the first half, higher mortgage rates notwithstanding. And it’s a well known fact that house prices in general have basically no correlation at all to mortgage rates, even though you’d think they would.

Bond funds aren’t exactly the same as houses, of course. But even if you think that we’re about to enter a long-term period where interest rates rise steadily, that doesn’t necessarily mean that you should divest yourself of all your bond funds. I haven’t read Simon Lack’s new book yet, where he advocates exactly such a course of action, but the fact is that market moves, by their nature, are generally unforeseeable. Even if your rate forecast is exactly right, there’s still a good chance that your decision to dump your bond funds might turn out to be a mistake.

4 comments

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

Most bond fund returns come from coupon payments (dividends). So a discussion of bond fund returns that ignores dividend reinvestment is sorely lacking. You can model the return of a theoretical long term bond fund investor during the bond bear market of 1950-1980 and see that their returns exceeded T-bills. A low bar maybe, but not the bond blood bath everyone is predicting.

Posted by nedofbaker | Report as abusive

I agree with nedofbaker.

“In fact, even the relationship between rising interest rates and bond fund prices is pretty opaque.” I don’t understand this statement. Yes, the underlying arithmetic is rather tedious. Bond funds, however, report average duration. A duration of 5 years means that the fund value drops about 5% for a 1% increase in interest rates. That is the definition of what duration means. I looked up duration for a bond fund that I own, and it took less than 5 minutes to do so.

Posted by realist50 | Report as abusive

Yes, total return would be more meaningful.

And I don’t know many individual investors who worry about the distinction between losing 8.6% and losing 7.8% in a single hypothetical scenario. Either way, a significant rise in interest rates would cost a year or more of return.

I’ve been building cash since the start of the year, as bond funds simply aren’t tempting yet. I’ve earned just a few pennies of interest, but that is still better than if I had held bonds over that period. When I am confident that five-year returns will be positive, I’ll consider bonds again.

Posted by TFF | Report as abusive

I would like to point out my passion for your kind-heartedness supporting men who really want guidance on this one matter. Your very own commitment to getting the message around had become extraordinarily beneficial and have in most cases helped women like me to get to their ambitions. Your own invaluable instruction signifies much to me and substantially more to my fellow workers. Many thanks; from all of us.

Posted by traducere daneza | Report as abusive