How Will Bond Funds Fare in a Rising-Rate Environment?

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How Will Bond Funds Fare in a Rising-Rate Environment?

Daniel Cross Dec 02, 2015

Mutual funds are arguably the most prolific investment product on the market and it’s easy to see why. Built-in management and diversification reduces risk and enables investors of all experience levels to gain exposure to the stock market. Fund types vary but are generally listed in three categories: equity funds, bond funds and hybrid funds.

As the Fed comes closer to announcing its first rate hike in nearly a decade, mutual funds are shifting their assets around to compensate for the new investment paradigm. While equity funds, and to a degree hybrid funds as well, are able to shift their holdings and weights in certain sectors to prepare for higher interest rates, investors may be concerned as to how bond funds will adapt.

Because bond prices fall as interest rates go up, a fund that invests solely in these types of debt instruments should be a poor investment until rates are done going up. However, these funds are more agile than investors realize and can still produce profits even when rates aren’t stable.

Breaking Down Bond Fund Holdings and Strategies

Bond funds don’t have as many investment categories as equity funds but they do have more than most investors realize. Bonds funds can invest in any or all of the following categories depending on what type of bond fund it is: short duration, corporate, mortgage, government, international, high-yield, municipal or a diversified grouping that contains a mixture of bonds.

When interest rates hold steady, bond funds generate profits primarily though the income generation of interest payments on debt holdings. A mixture of short-term and long-term debt creates diversification and stability in the portfolio.

If interest rates start to fall, bond values rise, which means profits can be made through capital appreciation of debt holdings. Longer-term investments are given a priority here since they will appreciate the most as overall yields fall. Bond funds typically outperform during these times.

When rates fall, bond funds are placed in a precarious position. Holding on to the debt obligations with a locked-in rate means that values will fall as interest rates climb. However, this doesn’t mean investors should eschew bond funds altogether. There are plenty of ways profits are still made.

One of the things bond funds overweight are floating-rate debt obligations. These securities allow for yields to adjust periodically as interest rates rise so that they don’t get stuck in a bond that’s losing value. Short-duration bonds are also an overweighted category for the same reason.

High-yield bond funds can be an attractive holding as well, although these carry far more risk than investment-grade issuances. High-yield bonds will offer more opportunities for profits but only if default rates don’t spike. A careful screening of companies that issue these types of debt obligations is critical here.

The Bottom Line

Overall, bond funds should be able to adapt to the new interest-rate environment. Funds that focus on shorter-term duration will outperform those that focus on longer-issue debt securities. Floating-rate debt obligations will help bond funds weather rising rates while select investments in high-yield bonds will help offset the decline of bonds with longer durations.

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