The effect of rising rates on Bond Funds

[VanWinkle]

I read this interesting article from a very intelligent poster on Bogleheads concerning the rising rates and how they affect a long term investor.


https://www.bogleheads.org/forum/viewtopic.php?p=6286231#


The idea that bond funds lose money is tied to short term thinking
about a long term investment. Short term bond funds will also make
money based on the interest rates of the bonds purchased within the
fund.

VW

 

[jazz4cash]

Not a fan of bond funds, but I agree and this should be helpful for anyone that is anxious about their bond fund holdings.

 

[mrfeh]

The idea that bond funds lose money is tied to short term thinking
about a long term investment. Short term bond funds will also make
money based on the interest rates of the bonds purchased within the
fund.

VW

Exactly. People that hold bond funds for the long run should be doing cartwheels that rates are going up.

Don't expect this to change minds though. The topic has been discussed many times here, and the ant-bond fund people only focus on the NAV drop.

 

[marko]

If I'm reading it correctly, there is a lag-time between the interest rate rise--and bond fund price drop (almost immediate)-- and the time that the bond interest rate catches up to make it profitable?

This is timely for me as I'm waiting to see how my bond fund interest pays out tonight.

 

[audreyh1]

Yep, my bond funds have been held for over 20 years of more or less annual rebalancing. When rates drop I don’t buy as much due to the NAV gains. As rates rise I’m buying more due to NAV dropping back again. I’ve been through many cycles so far. I don’t worry about other investors fleeing bond funds and causing losses, because at that time I’m buying more.

 

[OldShooter]

Sorry. Three contrived and unrealistic anecdotes prove nothing pro or con.

 

[RunningBum]

As I mentioned in https://www.early-retirement.org/forums/f28/vtapx-vs-vfsux-113803.html, in July 2020 I started getting out of bond funds and into TIPS funds due to concerns about poor bond rates and the likelihood that the fund would decrease in value as rates rose. Turned out to be a great move, as bond funds matched the dips in the rising interest rate charts from the OP's link, while TIPS funds did well.

I agree that for the long term you should be fine with bonds and bond funds.
I'm going to stick with TIPs for a little longer but will be looking to start moving back to bonds soon. I was and am market timing based on the probability of rising interest rates and the effect on bond values. I don't know how often I'll be willing to do this, but this time it seemed clear to me.

As I mentioned in the other thread I am not certain how much of the rising fed interest rate forecast is already priced into bond and TIPS values and rates. Do your own due diligence.

 

[audreyh1]

If I'm reading it correctly, there is a lag-time between the interest rate rise--and bond fund price drop (almost immediate)-- and the time that the bond interest rate catches up to make it profitable?

This is timely for me as I'm waiting to see how my bond fund interest pays out tonight.

The NAV itself dropping, which is almost immediate as you point out, means you are getting a higher yield when buying more, which would include reinvesting the interest or rebalancing.

The bond fund paying out increased amounts will take much longer.

 

[Montecfo]

I'm not negative on bond funds per se. To me the issue is more making sure you know what you own and understand the risks.

This is and has been an unprecedented period of quickly rising rates off of a historically low base. There has maybe never been a clearer time to avoid return-killing duration in your bond investments, whether held directly or through funds.

 

[VanWinkle]

Sorry. Three contrived and unrealistic anecdotes prove nothing pro or con.

Don't be sorry, some people appreciate seeing things from a different perspective.

VW

 

[daylatedollarshort]

Exactly. People that hold bond funds for the long run should be doing cartwheels that rates are going up.

Don't expect this to change minds though. The topic has been discussed many times here, and the ant-bond fund people only focus on the NAV drop.

So person A drops the bond fund, invests in a short term Treasury ladder until rates level off, and makes 2% nominal off the ladder. Then goes back to the bond fund in 1 -2 years. How does the person who stayed with the bond fund and lost 20% come out ahead of the short term Treasury person? I don't really get the math there. If you could give an example showing the math I would find that interesting.

 

[RunningBum]

This is and has been an unprecedented period of quickly rising rates off of a historically low base. There has maybe never been a clearer time to avoid return-killing duration in your bond investments, whether held directly or through funds.

This is a better way of saying what I tried to earlier.

 

[Phroig]

So person A drops the bond fund, invests in a short term Treasury ladder until rates level off, and makes 2% nominal off the ladder. Then goes back to the bond fund in 1 -2 years. How does the person who stayed with the bond fund and lost 20% come out ahead of the short term Treasury person? I don't really get the math there. If you could give an example showing the math I would find that interesting.

Exactly. Nobody’s advocating getting out of bonds forever, just until interest rates level off. In scenarios 2 & 3 in the Bogleheads post, you could get back into bonds 1-2 years after interest rates plateaued, and still be better off than if you stayed in.

 

[pb4uski]

If I'm reading it correctly, there is a lag-time between the interest rate rise--and bond fund price drop (almost immediate)-- and the time that the bond interest rate catches up to make it profitable?

This is timely for me as I'm waiting to see how my bond fund interest pays out tonight.

I didn't read the link, but yes, that is the way that it works. So for example, if you own a bond fund with a duration of 6 and interest rates spike by 2% the value of the bond fund declines by ~12%.

Over the next 6 years, the increase in rates recovers the decline in value and subsequent to that the investment benefits from the raise in rates.

https://www.core-wm.com/2018/11/29/...when rates are rising,returns in the long run

 

[pb4uski]

So person A drops the bond fund, invests in a short term Treasury ladder until rates level off, and makes 2% nominal off the ladder. Then goes back to the bond fund in 1 -2 years. How does the person who stayed with the bond fund and lost 20% come out ahead of the short term Treasury person? I don't really get the math there. If you could give an example showing the math I would find that interesting.

Exactly. Nobody’s advocating getting out of bonds forever, just until interest rates level off. In scenarios 2 & 3 in the Bogleheads post, you could get back into bonds 1-2 years after interest rates plateaued, and still be better off than if you stayed in.

Yes, exactly. Like the black line that I penciled in to a copy of the previous graphic.

 

[Dtail]

Currently and since 2019, I will take my rate risk through CD's and Stable Value funds earning 3%+.

 

[VanWinkle]

Yes, exactly. Like the black line that I penciled in to a copy of the previous graphic.

Agreed, and I should get out of stocks and buy back in only when they are going up....... You missed out on buying shares at a reduced price while the interest rate is increasing. You also miss out on cheaper shares by selling equities and waiting for the price to come back.

 

[Montecfo]

Agreed, and I should get out of stocks and buy back in only when they are going up....... You missed out on buying shares at a reduced price while the interest rate is increasing. You also miss out on cheaper shares by selling equities and waiting for the price to come back.

I do not think this is the same thing at all from a general perspective.

Having said that, if there has ever been a clearer view of interest rate direction than now, I'm not sure when that would have been.

And it's ok to ignore that and make no adjustments. But there has been a nice runway for making adjustments if you simply listened to the Fed. For me this goes back to January, 2021.

And the idea is not to "miss out" on anything except clearly telegraphed losses tied to duration (a concept which is relevant for equities also if you look at projected cash flows).

I am an active investor who advocates staying fully invested. Being value oriented I tend to sell what has gotten expensive and buy value relative to market conditions. That is what I do and what I am discussing here.

 

[pb4uski]

Agreed, and I should get out of stocks and buy back in only when they are going up....... You missed out on buying shares at a reduced price while the interest rate is increasing. You also miss out on cheaper shares by selling equities and waiting for the price to come back.

Fair point, but stock prices are much more random than bond prices... they didn't call it A Random Walk Down Wall Street for nothing.

At this point its in the bank that the Fed will increase 50 bps rates in May and pretty certain that they will further increase rates over the course of the year... so it is highly likely that bond prices will further decline in 2022 as these interest rate increases are made.

Given that, I think it would be foolish to slavishly stick ones head in the sand and stick with a bond fund that has high interest rate sensitivity just because you'll recover your interest rate losses in the long run when you can do better with little risk.

 

[daylatedollarshort]

Fair point, but stock prices are much more random than bond prices... they didn't call it A Random Walk Down Wall Street for nothing.

At this point its in the bank that the Fed will increase 50 bps rates in May and pretty certain that they will further increase rates over the course of the year... so it is highly likely that bond prices will further decline in 2022 as these interest rate increases are made.

Given that, I think it would be foolish to slavishly stick ones head in the sand and stick with a bond fund that has high interest rate sensitivity just because you'll recover your interest rate losses in the long run when you can do better with little risk.

That is exactly the difference. We have no idea when stocks will go up or down and they can make big moves in a single day. We know what is happening with bond funds with close to 100% confidence because the Fed has told us they have big rate increases planned, and interest rates just don't make sudden huge jumps in a single day. Investor A and B each have $10K in a bond fund. A switches to short term Treasuries and at the end of the Fed's planned rate increases and has $10,300 in fixed income at the end 2022. Investor B loses 15% in the bond fund and has $8.5K at the end of 2022. Investor A switches back to the bond fund and has a value of $10.3K in the fund.

Under what scenario could investor B come out ahead? At the end of 2022, A has $10.3K in the bond fund and B has $8.5K. Sure B might make up the difference over time, but he needlessly lost more money than he had to, given the free information from the Fed about the direction of interest rates. I would be interested in seeing a scenario how in a rising interest rate environment, B could come out ahead over A.

 

[Chuckanut]

Of course the Fed could change its mind or do a course correction if things change. Imagined what might happen to the world’s supply chains if China lost its zero Covid battle. Or, to Western economies if Mr. Putin dropped dead of a heart attack tomorrow.

We live in interesting times.

 

[foxfirev5]

Yeah, while I almost slipped back to bond funds for simplicity I'm sticking to my CD/Treasury ladders. While the equity Roth accounts go unnoticed DW and I will live off the ladders. Actually IMHO it's easier than managing duration and withdrawals from bond funds.

 

[RunningBum]

Agreed, and I should get out of stocks and buy back in only when they are going up....... You missed out on buying shares at a reduced price while the interest rate is increasing. You also miss out on cheaper shares by selling equities and waiting for the price to come back.

Who has missed out? All the charts I've seen here and elsewhere show bonds going lower if interest rates continue to rise, which seems very likely. Why buy now if they will probably be lower later?

Equities are harder to predict and I gave up market timing them a long time ago. Perhaps this year's downturn was easy to see coming but it has seemed just as obvious many times before and it often kept going up. Too hard to predict so I don't. This discussion is about bonds so I don't know why you even brought up equities.

 

[RunningBum]

BTW the referenced Bogleheads thread was mostly from October of last year, with the final post in late December. I believe the last couple of months of last year bonds were down, and YTD this year VG Core Bond Fund is -9.18% and VG Total Bond Index is -9.60%. The advice in that thread didn't age well.

 

[mrfeh]

BTW the referenced Bogleheads thread was mostly from October of last year, with the final post in late December. I believe the last couple of months of last year bonds were down, and YTD this year VG Core Bond Fund is -9.18% and VG Total Bond Index is -9.60%. The advice in that thread didn't age well.

Bogleheads don't care about returns over a 5 month period. People here shouldn't either.