For most of the past 30 years bonds and bond mutual funds have had the proverbial wind in their sails. However with interest rates at historic lows it is unlikely that bonds will perform as well over the next few years. Perhaps we are beginning to see some of this based upon the losses sustained by many bond funds over the past few weeks. Many investors are wondering if it is time to get out of bond funds. A key number that all holders of bond mutual funds and ETFs must know and understand is the fund’s duration.
What is duration?
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.
What does bond fund duration tell us?
The popular bond fund PIMco Total Return (ticker PTTRX) has an effective duration of 4.73 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 4.73%. Note this number is an approximation and bond prices can be impacted by factors other than changes in interest rates.
By comparison the T. Rowe Price Short-Term Bond fund (ticker PWRBX) has shorter duration of 1.69 years and would see less of an impact from rising interest rates.
The Vanguard Long Term Bond Index fund (ticker VBLTX) has a duration of 14.71 years and would see a serious decline in value should interest rates rise.
What should I do now?
As I mentioned above duration is a good indicator of the impact of a change in interest rates upon the value of your bond fund, but other factors also come into play. As an example 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. A case in point was Loomis Sayles Bond (Ticker LSBDX) which lost almost 22% that year.
Bonds are traded on the secondary market and prices are a function of supply and demand much like with stocks. Additionally part of a bond’s total return is also the interest paid.
Bond mutual funds and ETFs offer the advantage of a managed portfolio. On the flip side unlike an individual bond, mutual funds and ETFs never mature. I’ve recently read arguments for both types of fixed income investment approaches in the face of this new world for bonds.
Is it time to get out of bond funds? The point of this article is not to advocate that you necessarily do anything differently, but rather that you understand and evaluate the potential duration risk in any bond mutual funds or ETFs that you currently hold or may be considering for purchase. Bonds still have a place in many 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 the potential for rising interest rates is another phase in this evolution. As investors we need to understand the potential implications on our portfolios and adjust as needed.
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