(MarketWatch)If you have your money invested in bond funds, it’s time to sit up and take notice.
Friday’s strong jobs report has Wall Street penciling in higher interest rates this year and next — and if forecasts are right that could mean some very nasty losses for your bond funds.
According to the financial futures market, Wall Street now expects the Federal Reserve to hike short-term interest rates to 0.75% by the end of this year, 1.5% by the end of 2016, and well above 2% by the summer of 2017.
And Federal Reserve Vice Chairman Stanley Fischer has already warned that within a few years he expects those rates to be back to around 3.25% to 4%.
What would this mean for bonds?
In a nutshell: Bond prices typically fall in a rising interest-rate environment. That’s because a bond guaranteeing you, say, 2% a year for 10 years may be very attractive when short-term deposits only pay 0.25%, like now. But it becomes a lot less attractive when short-term deposits start paying 1%, 2%, or even more. Why would I want a piece of paper guaranteeing me 2% a year for 10 years when I can get 3% in my savings account?
So when short-term rates rise, bond rates have to rise to compete.
And bonds are like a seesaw: When the interest rate rises, the price falls.
How far will your bond funds fall when rates rise? And which bond funds are most vulnerable to rising interest rates?
Finance 101 (again) says the key to your bond fund’s vulnerability lies in a technical measure called the “duration.” It’s measured in months and years, and it’s basically a weighted measure of how long you have to wait to get your money back through coupons and the final repayment of the principal.
The longer the bond, the longer the duration. And the lower the yield, the longer the duration as well.
Bonds with a long duration suffer much more when interest rates rise than those with a short duration. As a general rule of thumb, a bond’s price will fall by 1% times its duration for every 1% rise in short-term rates.
So a fund with a five-year duration is likely to fall 5% if the Fed hikes rates by 1%, and 10% if it hikes rates by 2%, and so on.
Real life rarely works out quite so neatly, partly because financial markets anticipate. The bond market won’t wait till the day the Fed hikes rates to sell off bonds. It will happen long before.
The biggest danger here for ordinary investors is that they have been told by any number of financial salesmen that bonds are “safe haven” investments suitable for the elderly and those afraid of taking on risk. The same people promising bonds are “safe havens” may also be those pointing out how far bonds have boomed since the Fed began slashing interest rates — as if “safe haven” assets are ones that boom, and if something that booms can’t also crash.
So which of your bond funds are most at risk?
Everyone’s portfolio will be different, and your bond-fund manager will be making his or her own bets. But a look at the main bond index funds — for example, those run by Vanguard — tells us how vulnerable the average fund is.
Bottom line: It’s not just your long-term corporate and Treasury bonds that are at risk.
Intermediate bond funds, high-yield funds, and inflation-protected Treasury funds will all get hit when rates rise. And “safer” bonds are likely to get hit harder than “risky” bonds, because supposedly “safer” bonds typically have lower yields —- and hence longer duration.
So Treasury bonds are likely to fall further than investment-grade corporate bonds, and investment grades further than “high-yield” or “junk” bonds.
Using data from index bond funds as a useful guides to sector averages, here’s what a 2% rise in interest rates would mean to various bond funds:
• Long-term Treasury and corporate bonds: Down 30%.
• Inflation-protected bonds: Down about 15%.
• Intermediate term bonds: Also down about 15%.
• High-yield bonds: Down about 10%.
• Municipal bonds: Down about 10%.
Naturally there are some caveats: Among them, the markets could be wrong and the Fed might not raise rates so much after all. But I’d probably listen to the Fed’s own vice chairman when it came to rates — and note that the percentage declines cited above are based on just a 2% rise in short-term rates. If they rise to 4%? Ouch.
By
BRETT ARENDS
APAC Financial Markets • #BondFund, #Crash, #RisingInterestRates, #ROI #MarketNews
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