Friday, November 30, 2012

How the 10 Largest Bond Funds Will React when Interest Rates Risetitle

In a recent article over at The Reformed Broker, Josh Brown points out that bond investors are setting themselves up for a bloodbath that they don’t even see coming.  What’s the bloodbath he is talking about?  The fact that when interest rates start rising, bond funds are going to start falling in value.
The concern that he and many other financial professionals have is that many of these investors don’t even realize that they are exposing themselves to this risk.  By fleeing the stock market and running into bonds, they may be jumping out of the frying pan and into the fire.

Are Bond Fund Investors Setting Themselves up for Disaster?

How much will your fund fall in value if interest rates rise?

What many of the articles do not mention, is that when it comes to their reaction to rising interest rates, not all bond funds are created equal.  So the question is not really should you not invest in bond funds if you think interest rates are going to rise, but which bond funds should you invest in?
Although it is a bit of a crude method, one of the easiest ways to get a feel for how much the value of a bond fund will drop when interest rates rise, is by looking at the fund’s duration.  Duration is a measure of interest rate risk, and is normally listed on the fact sheet of the fund.  If you can’t find it there, its usually on the fund’s overview page at as well.
The longer the duration of a fund, the more the value of the fund will rise and fall when interest rates move.  If a fund has a duration of 1, then when interest rates rise by 1%, the fund’s value should fall by roughly 1%.  If a fund has a duration of 5, then that same 1% rise in interest rates will result in a roughly 5% drop in value of the fund.  (You can learn more about duration here.)

Assets Under Management (Millions)
Loss Per 1% move higher in interest rates
1. PIMCO Total Return Fund
- 4.82%
2. Vanguard Total Bond Market Index
3. Templeton Global Bond Fund
4. Vanguard Inflation Protected
5. Vanguard Short Term Investment Grade
6. Vanguard GNMA
7. DoubleLine Total Return
8. American funds Bond Fund of America
9. JP Morgan Core Bond A
- 4.49%
10. Lord Abbett Short Duration Income
- 1.80%
While these are rough estimates, it should be noted that two of the above funds will likely behave differently than their duration would suggest. The first is the Vanguard Inflation Protected Fund. If interest rates and inflation move higher together (which is no longer a given), then the fund should be less impacted than its duration suggests. On the other hand, the Vanguard GNMA should be more impacted than its duration suggests. The duration of the Mortgage backed securities which the Vanguard GNMA fund holds tends to rise with interest rates.

Should one buy the funds with the lowest duration and which are the least vulnerable to rising interest rates? Not necessarily.  Longer duration funds normally pay more yield than shorter duration funds holding similar type bonds. To help you decide which fund is right for you, visit the LB Ratings page here at Learn Bonds.

No comments:

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.