#interest #rates #bond #prices
Your bond funds will do this when interest rates rise
(This is the first of a two-part series on the risk faced by investors who hold shares in bond funds as interest rates rise. The second part covers alternatives to bond funds for income-seeking investors.)
“I’m glad I bought my wife a new car this year, because it’s not a great time to pour more cash into the market.”
That is what a retired investor, who always makes long-term picks with a focus on income, said to me recently.
An income-seeking investor who focuses on stocks? Yes.
Over the past decade, bond yields have declined, and trust preferred stocks have been disappearing in light of changes to regulatory capital requirements. Meanwhile, many recent preferred-stock issues have been designed for institutional investors, with high share prices, often $100,000. Institutional investors also tend to snap up new preferred issues quickly, squeezing out small investors who prefer to buy newly issued shares “off the shelf” to avoid commissions.
A quick review of interest rate risk
The market price of an individual bond will fluctuate in the opposite direction of interest rates. For example, if you purchase a $10,000 bond at par value (or face value) with a coupon (yield) of 4%, your annual income is $400. If interest rates rise and a newly issued bond with an identical rating pays 4.5%, the market value of your bond declines to $8,889. The market value declines so that if you sell your bond, the buyer, who will be receiving $400 in interest per year, will have a yield of 4.5% on his or her investment to match the prevailing market rate.
A market-value drop of 11% might seem pretty scary, but if you don’t sell your $10,000 bond, you will lose nothing, as you continue to enjoy your $400 in annual income, and you will get all your cash back when the bond matures. So in that case, the decline in market value doesn’t make any difference.
Why not invest in a bond fund?
Why not buy shares in a bond fund? They certainly are popular, with investments in open-ended bond funds totaling $3.3 trillion, according to FactSet. A bond fund is a simple way to invest for current income, without worrying about making individual picks and with the advantage of diversification. But the problem is that the mutual funds have fluctuating share prices.
If you hold shares in a bond fund, you don’t have the choice of holding your investment until maturity, to avoid a market-value loss, as you do when holding an individual bond. You are riding the market values up and down each day, and if you get slammed in a rising-rate environment, there’s no guarantee that you will ever make up your capital losses when interest rates eventually begin to decline again.
This means that at a time when short-term interest rate are near zero, 10-year U.S. Treasury notes TMUBMUSD10Y, +1.95% are yielding 1.89% and the Federal Reserve is considering the timing of interest-rate increases. bond-fund investors are being set up for big losses.
How much might you lose?
Here’s an example. The Vanguard Long-Term Corporate Bond Index Fund (Admiral Shares) VLTCX, +0.56% has a lovely 30-day yield of 4.09%, although nearly 48% of the bonds held by the fund have ratings below “A,” according to Morningstar, which uses data from Barclays that combines ratings of the three major ratings agencies.
The average duration for that bond fund is 13.9 years. The duration is described by a long-time corporate bond portfolio manager as “a back-of-the-envelope calculation of how much your principal value will change if interest rates were instantly to move up or down by 1%.”
Five years ago, the 10-year note had a market yield of 3.71%, nearly 2 percentage points higher than its yield now. You might find it hard to imagine the rate going back up to that level because the current down cycle has lasted so long, but 3.71% is not a high yield on a historical basis.
For less interest-rate risk, you might consider a bond fund with shorter maturities, such as the Vanguard Intermediate-Term Corporate Bond Index Fund (Admiral Shares) VICSX, +0.25% which has an average duration of 6.4 years. Then again, the fund’s 30-day yield is only 2.90%, and nearly half of the bonds held by the fund are rated below “A.”
What should an income-seeking investor do?
It’s a good idea to have a hear-to-heart talk with your investment adviser, especially if you are sitting on large positions in bond funds. If you begin scaling out of the funds now, chances are that you will enjoy some tidy capital gains.
The bond-fund yields just aren’t high enough to warrant the risk you are facing when interest rates are already so low. We cannot say just when interest rates will rise, and there is so much excess liquidity in the world that the Swiss government was able to sell 10-year bonds on Wednesday with yields below 0%. while the Mexican government sold 100-year bonds with yields of 4.2%.
But the United States is likely to see interest rates begin to rise this year based on the evolution of policy statements by the Federal Reserve.
For alternatives, ask your broker for assistance in identifying new preferred-stock issues that you might be able to take advantage of. You may also want to consider large-cap common stocks that feature relatively high yields. Among the S P 500 SPX, +0.17% there are 34 stocks yielding more than 4%, according to FactSet.
Please see part 2 of this series for more on income alternatives to bond funds.
Some large-cap companies with high dividend yields on common shares may have to cut their dividends, especially the ones in the beleaguered energy sector. So the next step is to narrow your choices to companies with sufficient free cash flow, which enables them to raise their dividend payouts.
With the media and investors fixated on every word that comes out of the Federal Open Market Committee or the constant flow of comments from regional Federal Reserve Bank presidents, nothing will be safe in the aftermath of an actual policy change by the Fed. Common stocks are likely to fall, at least over the short term, following a rate hike. Then again, you might have some dry power to invest after a decline, and for common stocks with attractive dividends, supported by strong free cash flow, even if you suffer a decline in market value, you will receive your dividend and have prospects for long-term capital growth.
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