How Rising Interest Rates Affect Bond Funds

Finance

The odds of an interest rate rise seem to be increasing. After the October jobs report revealed that the US economy added 271,000 jobs that month and the unemployment rate fell to 5%, predictions that the Federal Reserve would raise interest rates proliferated. Prices in futures markets currently imply that there’s almost a 75% chance that the Fed will hike interest rates in December.

As we’ve argued in the past, you probably shouldn’t fret too much about the Fed. Given the low inflation rate and struggling global economy, even if the Fed takes action in December it’s unlikely to raise rates very far or very fast.

But that doesn’t mean Fed policy will have no effect at all. In fact, the Fed’s actions can affect virtually every investment. One type of investment most likely to be affected will be bond funds. Bonds tend to hurt by rising interest rates since higher interest rates often increase bond yields, and bond yields move in the opposite direction of bond prices. Since bond funds are essentially just a collection of individual bonds, by this logic bond funds should be hurt by rising interest rates as well.

This relationship, however, isn’t quite that simple. Bond funds are indeed hurt if the bonds they hold fall in value due to higher yields. But bond funds are also continually buying new bonds, not just holding on to their existing ones. Over time, the gains from higher yields on these new bonds will partially compensate for the initial decline in bond prices. If you hold the bond fund long enough, your return is likely to be close to the fund’s yield when you first bought it, regardless of what happened to interest rates during that time.

How much you should worry about the effect of rising interest rates on your bond funds therefore depends not only on what the Fed does, but also on the length of your investment horizon. There are ways to minimize the risk of being hurt by rising interest rates, such as by shifting your bond holdings toward shorter-term bonds. But depending on factors such as your investment horizon and your risk tolerance, such tactics may not be necessary.