Investing in bond funds when interest rates rise

The last time investors faced rising interest rates, one of us was investing paper route money and other wasn’t even born yet. In other words, the idea of a rising rate environment isn’t something we, or most advisers, have ever had to deal with. For bond investors, it’s worth giving some thought to what happens to different bonds when interest rates rise.

Whether real interest rates will rise in the future is debatable, but most economists project that bonds won’t provide much return after inflation. However, nominal interest rates could rise if inflation picks up and the federal government continues its expansionary policy.

As we know, when nominal interest rates rise, our old bonds that pay lower interest rates become less valuable. This is why we’ve estimated that initial intermediate-term bond yields explain 92% of actual bond returns over a 10-year period. Even if interest rates go up, the value of existing bonds falls, and we’re left with low returns even when new bonds have higher yields.

A quick primer on bond mutual funds. Bond portfolios are commonly grouped according to their maturity and their credit quality. With respect to maturity, ultra-short-term bonds typically have a maturity of less than a year and are also referred to as cash funds since their value is generally unaffected by changes in interest rates. Although definitions may vary, short-term bond funds typically have a maturity of less than four years, intermediate-term bonds have a maturity between four and 10 years, and long-term funds hold bonds have a maturity longer than 10 years.

Since there’s no standard definition, you’ll want to check the duration of the bond fund to get a better idea of its sensitivity to changes in interest rates. According to Morningstar Inc., short-term U.S. bond funds have a median duration of 2 years, but 3.66 years at the 95th percentile. That’s actually higher than the 5th percentile of intermediate-term bond funds, at 3.42 years duration.

The median duration of long-term U.S. bond funds is 11 years, but ranges from 7.52 years at the 25th percentile to 14.72 years at the 75th percentile. Since duration measures the sensitivity to interest rates, this is a big deal if clients see a 7.5% drop on their long-term bond portfolio from a 1% increase in interest rates instead of a 14.7% drop.

Between 1926 and 2017, the generally positive yield curve resulted in higher returns on longer-term bond funds. The average return on cash has been 3.4%. Intermediate-term funds have provided a significantly higher return (5.1%), and long-term bond funds have given investors a slightly higher return than that (5.5%). It’s worth noting that investors haven’t received much of a premium for moving from intermediate- to long-term bonds in the past, but they have experienced significantly more risk, due to the longer durations of long-term bonds.

(More: Bond dilemma requires new thinking)

Another important consideration is that longer-term bonds have gotten a lot riskier in recent decades. If you’re estimating the potential volatility of a bond portfolio using the standard data from 1926 to the present, then you may not be giving clients a false sense of security.

Between 1926 and 1975, the standard deviation of intermediate-term bonds was 3.57%. After 1975, it’s 6.78%. The standard deviation of long-term bonds has risen even more dramatically, from 5.44% to 12.51% after 1975. Cash continues to be boring, but in a rising interest rate environment, boring is a very good thing.

Should investors consider long-term bonds if the standard deviation is much higher and the return is only slightly higher than an intermediate-term bond? Historically, interest rates have fallen or risen over long periods of time. Although there is some evidence that interest rates do revert to the mean, this mean reversion can take decades for bonds (instead of the length of a business cycle for stocks). This means that long-term bonds can significantly underperform, or outperform, intermediate-term bonds for an extended period of time.

The rising interest rate environment of the 1970s resulted in lower performance for long-term bonds than cash for more than a decade. If you’d invested in long-term bonds in 1960, by 1980 you’d have a little less than doubled your money with a standard deviation of 6.56%. That compares to a roughly tripling your money with a standard deviation of just 2.35% if you’d invested in cash. In only seven years between 1960 and 1980 did long-term bonds beat cash (intermediate-term bonds were only slightly better, outperforming in just years).

Simply put, a rising interest rate environment can result in returns on cash that are higher than returns on longer-term bonds. Investors in long-term bonds get all the risk but none of the return.

It’s been a long time since investors have faced a rising interest rate environment. Many investors have become accustomed to the notion that greater bond risk will bring clients higher returns. Today’s low interest rates may tempt many clients and advisers to reach for extra yield by increasing the duration of their bond portfolio. If rates rise, they may be in for a shock that we haven’t seen in decades.

(More: The good, but mostly bad, of rising interest rates)

Michael Finke is chief academic officer of The American College of Financial Services. David Blanchett is adjunct professor of wealth management at The American College and head of retirement research for Morningstar Investment Management.