How Rising Interest Rates Impact Bond Funds

Even with rising interest rates, bonds can be a crucial diversifier

Sara Silano 5 September, 2022 | 9:46AM
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Storm ahead sign

It's not been easy being a bond investor lately. Returns take a significant hit depending on changing interest rates and, with inflation reaching new heights, bond and fixed income investors should be paying attention.

On the inflation side, energy prices remain a key factor. As Russia’s Gazprom conducts Nord Stream 1 "maintenance" and causes a gas price spike, investors are right to be worried.

This August, inflation was measured at 9.1 percent across the 19 euro countries, year-on-year, by Eurostat. This is the highest level since the currency’s inception in 1999, and miles off last year’s 2.2%. And in the UK, inflation hit 10.1% while Citigroup has forecasted a peak at 18%.

This can lead to further challenges for bond investors. Additional interest rate hikes across Europe are expected in the coming months, starting with the European Central Bank’s meeting on September 8. Its latest hike was in July, raising the rate by 50 basis points, with a view to continuing its "data-dependency" to deliver on its 2% inflation target over the medium term.

What Does This Mean For Bond Funds?

When interest rates go up, investors can purchase-newly issued bonds with a higher interest rate while previously issued bonds with lower yields are consequently worth less.

However, investors who purchase individual bonds and hold them to maturity will eventually be made whole when they redeem their holdings at par. The proceeds can be invested in bonds with a higher interest rate, leading to better future returns. In fact, it is relatively rare for bonds to suffer two or more consecutive years of losses, even during periods of rising interest rates.

A fund manager who holds bonds with different maturity dates will reinvest the proceeds as each matures. That allows for more generous coupons during periods of rising interest rates, and, thus, better future returns.

But not all bonds and the funds that invest in them are impacted equally.

Long-term bonds tend to be particularly hard hit in an environment of rising interest rates. Since the beginning of the year, the Morningstar Euro Long Term Bond category has lost about 25% and the Euro Government Bond category has lost 11.09%.

In contrast, short-term bonds are less affected. Since January 2022, the Euro Government Bonds - Short Term category has lost 1.85% while the Euro Ulta-Short Term Bonds category is down -1.46%.

Times Like These

Going forward, the ECB’s path seems charted, so investors should expect further rate hikes. But in July, its president Christine Lagarde gave no clues as to the size and number of future increases. In a challenging economic environment, it is difficult even for central bankers to make predictions about inflation trends and thus the effectiveness of monetary policy decisions. As such, investors should be prepared for further phases of weakness in their bond portfolios.

Indeed, European fixed income funds experienced their sixth consecutive negative month in July, with €2.3 billion in redemptions. This year, investors have withdrawn €88.4 billion.

Don’t Give Up on Bonds

But investors shouldn't give up on bonds altogether because fixed-income securities still play a critical role in reducing portfolio risk, and can be surprisingly resilient, even in periods of inflation and interest rate turmoil, according to Amy Arnott, portfolio strategist for Morningstar.

"Bonds' ability to control risk is partly because they're fundamentally different from stocks. Bondholders receive periodic interest payments in exchange for lending money to the bond issuer. Stocks, on the other hand, might pay dividends, but any payments to shareholders are optional," she says.

"Bonds typically have much steadier performance than equities. Since 1926, for example, stocks have suffered 119 quarters of negative returns. During about two thirds of those periods, bonds had positive returns."

Another diversification benefit is bonds’ low correlation with stock movements.

Even during periods of rising interest rates, bonds usually have a lower correlation with stocks than most other major asset classes, thus reducing portfolio risk. Morningstar analysis of previous stress periods for inflation and interest rates indicate that stock/bond correlations have rarely increased above 0.6, and then only during the most acute periods of rising rates and/or inflation.

What is the Best Bond Fund for Me?

But importantly, investors should not be getting bogged down in attempting to predict inflation spikes or interest rates. Instead, the focus must be on their own financial needs.

"For your very near-term outlays, if you're retired and you have expenditures for the next couple of years that you'll be withdrawing from your portfolio, my bias would be just to keep that money in cash, not take any interest-rate-related risk," says Christine Benz, director of personal finance for Morningstar. 

"You may see its value get eaten up a little bit by inflation, but I think that generally speaking, you'd rather be safe than sorry with that portion of the portfolio.

"If you have funds that you expect to spend in the next two to five years, there you might hold short-term bonds, which will have much less interest-rate sensitivity.

"Finally, if your time horizon is five to 10 years, you might hold medium- to long-term bond funds, with some confidence that over your particular time horizon bonds will likely be in positive territory."

That’s according to historical data at least. The future of bonds is still all to be written.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Sara Silano

Sara Silano  is Editorial Manager for Morningstar Italy

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