For most of the past 30 years bonds and bond mutual funds have had the proverbial wind in their sails. Interest rates have steadily headed downwards. Bond prices and interest rates have an inverse relationship.
Last week, however, the Fed increased interest rates by 25 basis points (0.25%). They also indicated that they would continue to raise rates this year as, in their view, our economy has reached a new phase. This is part of an overall tightening of the money supply to keep the economy from overheating, including an effort to keep inflation in check.
Many investors may be wondering what this means for their bond mutual funds ETFs. A key number that all holders of bond funds and ETFs must know and understand is the fund’s duration.
What is duration?
Bond mutual funds and ETFs are a portfolio of individual bonds.
According to Morningstar, “Duration is a time measure of a bond’s interest-rate sensitivity, based on the weighted average of the time periods over which a bond’s cash flows accrue to the bondholder.” A bond’s cash flows include the value received at maturity, generally $1,000 per bond, and the periodic interest payments received by the holder of the bond. A bond’s duration is expressed in years and is generally shorter than its maturity.
All things being equal, a bond with a longer time to maturity will have a higher duration meaning its price is more sensitive to changes in interest rates. Likewise, the higher the bond’s coupon rate (the stated interest rate paid by the bond) the lower the bond’s duration. Bonds with a shorter time to maturity and a higher coupon rate will have a lower duration and their price will be less sensitive to changes in interest rates.
The duration of a bond fund or ETF can be found on the fund’s fact sheet usually posted on the fund company’s site, or the portfolio tab on the fund’s listing on Morningstar.com.
What does bond fund duration tell us?
The largest bond fund, Vanguard Total Bond Market Index (ticker VBMFX), has an effective duration of 6.05 years according to Morningstar. This tells us that if interest rates rise by 1% the value of the underlying bonds held by the fund would likely decline by around 6.05%. Note this number is an approximation and bond prices are impacted by factors other than changes in interest rates. This fund roughly tracks the aggregate U.S. bond market.
By comparison Vanguard Long-Term Investment Grade (ticker VWESX) has longer duration of 13.31 years and would see a greater impact from rising interest rates.
The Vanguard Short-Term Bond Index ETF (ticker BSV) has a duration of 2.76 years.
The actively managed Double Line Total Return Bond Fund I (ticker DBLTX), managed by Jeffrey Gundlach who many call the “bond king,” has a duration of 3.98 years.
What should I do now?
As mentioned above, duration is a good indicator of the potential impact of a change in interest rates upon the value of your bond fund, but other factors also come into play. In 2008, many bond funds saw outsized losses and investors moved their money into Treasuries as a safe haven during the financial meltdown.
Many high-quality bond funds suffered major losses that year based only upon this flight to quality by investors.
Longer term the total return of a bond fund or ETF is driven by income payments as well as the direction of interest rates. Lower coupon bonds will be replaced by bonds with higher coupon rates over time.
Bonds are traded on the secondary market and prices are a function of supply and demand much like with stocks.
Bond mutual funds and ETFs offer the advantage of a managed portfolio. On the flip side unlike an individual bond, bond mutual funds and ETFs never mature.
Is it time to get out of bond funds? The point of this article is not to advocate that you do anything differently, but rather that you understand the potential duration risk in any bond mutual funds or ETFs that you currently hold or may be considering for purchase.
Bond funds and ETFs still have a place in diversified portfolios, but for many investors the characteristics of the fixed income portion of their portfolios may need an adjustment. This might mean shortening up on bond fund duration and looking at other, non-core types of bond funds.
The landscape of the financial markets is continually evolving and interest rates are a part of this evolution. As investors we need to understand the potential implications on our portfolios and adjust as needed.
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