For a number of years we have been discussing the interest rate environment, commenting on the low rates and having discussions regarding when and how quickly rates may go up. Keep in mind that at least a portion of this scenario was intentional, as the Federal Reserve Bank lowered short-term interest rates to extremely low levels to help pull the economy out of severe recession back in 2008 and 2009.
While the Federal Reserve can directly control short-term interest rates, the market sets long-term rates based on the its expectations for inflation, among other factors. The yield on the 10-Year U.S. Treasury bond at its low point was under 1.4% back in the summer of 2016 (Bloomberg). Last week it rose to 2.94%, which is about the highest level we have seen in the last four years. Solid employment numbers in the U.S. and overall positive global economic growth are getting most of the press as the primary drivers of the increase.
While we believe that it is extremely difficult to predict the future path of interest rates, we also think it makes sense to periodically revisit some bond investing fundamentals.
First, a quick refresher on duration, an important term related to bonds. Duration is a measure of interest-rate sensitivity. In general, the longer the maturity of a bond, the longer the duration, and therefore the more sensitive that bond is to changes in interest rates. Given that bond prices move inversely to interest rates, the prices of long-term bonds will adjust (up or down) to a greater extent than those of short-term bonds as interest rates change.
When rates are going down, a portfolio of longer-term bonds will typically outperform a portfolio of short-term bonds, and vice versa when interest rates are going up. Each individual bond has a duration, and a bond fund has an estimated weighted duration based on the underlying holdings.
Individual Bonds vs. Bond Funds
Most investors should hold some portion of their portfolio in bonds, regardless of the interest rate environment. When it comes time to implement the investment, it can be done through either individual bonds or bond mutual funds.
Some investors prefer individual bonds, as they take comfort in knowing that as long as they hold the bond until maturity, and there are no issues with the credit of the issuer, they will get 100% of their principal back.
Bond funds behave a little bit differently. With no set maturity for a bond fund, the value of the fund will fluctuate as the interest rate environment and other factors change. In a rising rate environment, it is likely that the value of the fund will go down for a period of time. However, it is also likely that the income stream from the bond fund will go up during the period of rising rates, as some of the underlying bonds mature or are sold and replaced with bonds paying higher interest rates.
Bond funds also provide additional diversification and liquidity characteristics, and may provide active management, depending on the fund being used. Actively managed bond funds will also have some sort of duration target. It is set by the management team and reflects their stance on whether interest rates will go up or down. Bond funds will, however, have some additional cost in the form of the expense ratio of the fund.
While each situation and investor is different, we do believe that the diversification and liquidity benefits that come with bond funds are attractive characteristics and make good sense for the typical investor. However, neither of these choices is right or wrong, and, if held for a full interest-rate cycle, we believe that the total return of a bond fund will be very similar to that of a portfolio of individual bonds with similar characteristics.