Perils of bond funds in a rising rate environment

In the discussion on rising interest rates, the real question isn't if they will rise, it is when. Given this reality, it is worthwhile to evaluate the risk of owning bond mutual funds versus individual bonds in a rising interest rate environment.

One basic principle of bonds is that when interest rates rise, the value of individual bonds typically declines. Here's a simplified example to illustrate why. Let's say a bond maturing in five years is currently paying a coupon of 3 per cent. Hypothetically, if interest rates rise, newly issued five-year bonds may pay 3.5 per cent interest.

Since these newly issued bonds are paying more income, the bonds would sell for less than the newly issued bond paying the higher interest. No one is going to pay the same price for bonds that pay less interest. The value of the bond declined as interest rates rose.

Though the value of bonds can move up and down, it is less of an issue of whether the bond is held to maturity. If a bond is held to maturity, the bond will continue to pay the stated interest and will mature at full value. If, however, one wishes to sell the bond when interest rates rise, they may find the value of the bond has declined. As long as individual bonds are held to maturity, the investor knows exactly what they will get and when. This is where the evaluation of owning individual bonds versus bond funds comes into focus.

In bond funds, there can be hundreds, if not thousands of bonds in the portfolio. An investor buys into the bond fund at the Net Asset Value, or NAV, of the fund and owns a slice of the portfolio of bonds. As interest rates rise, and if the portfolio manager continues to keep the same bonds in the portfolio, the value of the bonds in the portfolio will decline, as will the NAV.

If the investor wants to liquidate the position in the bond fund, the amount received may be less than was originally invested. In addition, the NAV can be adversely impacted if the bond fund manager has to sell bonds for less than they were purchased for as a result of having to raise cash to cover redemption requests.

So, how can you protect yourself?

When investing in bond funds in a rising interest rate environment, consider bond funds that invest in bonds with shorter maturities. Shorter-term bonds will generally be less volatile than longer-term bonds when interest rates rise. If interest rates are rising as those shorter-term bonds mature, the proceeds can be reinvested into bonds paying a higher interest rate. With longer maturity bonds, one is locked in for a longer period of time, and this can make those bonds more volatile in a rising rate situation.

Another option is to consider buying high credit quality individual bonds instead of bond funds and holding those bonds to maturity. You will receive the stated interest rate and the full value at the bond's maturity, thus avoiding the problem of the decrease in value of the bond during the interim if interest rates rise.

Lastly, consider laddering individual bonds over a period of years. This means building an individual bond portfolio with bonds of various maturity dates. This tends to help protect an investor in both rising and falling interest rate environments.

For example, if an individual portfolio is comprised of 10 bonds, each with a maturity from one to 10 years, as each bond matures it is reinvested in a bond maturing in 10 years. Regardless of whether interest rates are going up or going down, as each bond matures a new 10-year bond is purchased.

This strategy tends to smooth out the effects of bond rates either rising or falling, since each year a new 10-year bond is bought at the prevailing current interest rates. So, if interest rates rise, each year a bond will mature that can then be reinvested in a bond paying a higher interest. On the other hand, if rates fall, only one bond is maturing that will have to be invested at the lower interest rate. The rest of the bonds are still paying the higher interest Source: US News and World Report