Interest rates have remained low due to the U.S. Federal Reserve’s decision to hold off on raising rates for the first time in nearly a decade. This has resulted in a prolonged period of strong performance for the fixed-income market. This year, many types of fixed income have even outperformed the equity market. For example, the
Vanguard Total Bond Market Index Fund (
VBTIX) has returned 1% this year through September 30, not including its 2.5% yield, which has added to returns.
Bond mutual funds have clearly benefited from the multi-year period of historically low interest rates. But that outperformance may not last as the Federal Reserve is widely expected to finally raise interest rates at some point in the next few months. Investors may want to consider interest rate risk in the fixed-income market before investing.
Strong Performance of Bond Funds
So far this year, bond mutual funds have performed well. The continued low-rate environment has benefited fixed-income, and specifically high-yield bonds, which are the most sensitive to rates. For example, the
Fairholme Focused Income Fund (
FOCIX)
has returned 7% to investors year-to-date, which is far better performance than the equity market.
Other types of fixed income are also benefiting from low rates, not just high-yield bonds. For example, U.S. Treasury bonds have provided satisfactory returns. The U.S. 10-Year Treasury Bond yield remains at 2.1%, which has kept investor appetite for Treasury bonds robust. Mutual funds oriented towards government bonds are benefiting from this as well. However, bonds will be adversely affected by rising rates. Here is what investors should know about rising rates and what they mean for fixed income.
The Impact of Rising Rates
Fixed-income securities perform well when rates are low and perform poorly when rates increase. This is because, fundamentally, higher interest rates raise the cost of debt. Higher rates usually lead to investors selling fixed income as price and yield are inversely related; previously issued bond securities with lower yields are less attractive once interest rates go up.
An investor will likely sell these previously issued bonds to reinvest in newer, higher yielding issues. To incentivize investors to buy lower yielding, older bonds, the price will need to decline to make the yield competitive with newer, higher yielding securities.
Consider Risks before Investing
Bond funds have enjoyed strong performance thus far in 2015. The fixed-income market has generally outperformed the equity market year-to-date. However, bonds carry outsized interest rate risk that investors should consider before investing. The U.S. Federal Reserve’s decision to keep interest rates at zero will likely be short term. Several Federal Reserve Bank governors and other federal officials have implied that rates will rise soon, perhaps this year. For example, in an
Associated Press article published on October 12, in a survey of 50 economists conducted September 16 to 23, 79% of respondents expect a U.S. interest rate increase by the end of this year.
This should negatively impact bond mutual funds. Higher interest rates typically result in lower prices of fixed-income securities since yield and price are inversely related. As interest rates increase, prices tend to decrease in order for bond yields to rise accordingly with rates. Therefore, the rally in bond mutual funds this year could prove to be short-lived.
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