I’ve been getting quite a few questions lately on what will happen with bond funds in the portfolios when interest rates begin to rise. This is a very good question. At some point, the Fed will start raising interest rates. When interest rates do rise, bond prices will fall. Falling bond prices lead directly to investor losses. What, if anything, can be done? There are a couple ways to minimize losses, or even take advantage of rising interest rates.
One solution is to stick with my management philosophy of replacing underperforming funds each year when portfolios are rebalanced. By looking at a bond fund’s duration and maturity, it is possible to identify funds that will do well during a rising rate environment. Schwab has a wide range of bond funds available and some will do well as rates rise.
Another way to minimize losses when heading into a rising interest rate environment is to choose bond funds with low “duration.” Stated as a numeric value, a bond fund’s duration indicates the change in value to the fund, depending on whether the interest rates rise or fall.
For example, let’s say a bond fund’s “duration” is equal to 7. The way to determine the effect on a portfolio is as follows: If interest rates rise 1%, then the value of the bond fund will decrease by 7%. If interest rates fall 1%, then the value of the bond fund will increase by 7%.
The lower the “duration,” the less a bond fund will lose when interest rates rise. Replacing underperforming bond funds with low duration bond funds minimizes future losses if interest rates rise.
A way to take advantage of rising interest rates is to choose bond funds with low “maturity.” Stated as a numeric value, a bond fund’s maturity indicates the average number of years before all of the bonds in the portfolio mature (or the principal is returned to the investor).
Bond funds with a low “maturity” indicate that the fund manager will be adding new bonds to the fund more frequently because the bonds in that fund mature sooner. When new bonds are purchased, they get the prevailing rate, which means the bond fund manager can take advantage of buying higher interest rate bonds.
Now that we understand bond duration and maturity, let’s look at where the portfolios are presently. The data below are from the Moderate portfolios (from Q1 2013), which have a 40% bond and cash allocation.
|Moderate (Low Min)||7.64||5.29|
A typical intermediate bond (a bond that matures in 5-10 years and is considered to be an average bond), has a maturity of 5-10 years and a duration of 5-8. Looking at the moderate portfolios as they are now, they have a below average maturity and a below average duration.
Going forward, I will look for replacement bond funds with a low maturity and a low duration – in addition to my normal ranking criteria. By doing this, I hope to minimize losses when rates rise, and capitalize on them over the long-term.