Why do bond funds lose value when interest rates rise?
What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.
Most bonds and interest rates have an inverse relationship. When rates go up, bond prices typically go down, and when interest rates decline, bond prices typically rise.
High-quality bond investments remain attractive. With yields on investment-grade-rated1 bonds still near 15-year highs,2 we believe investors should continue to consider intermediate- and longer-term bonds to lock in those high yields.
As for fixed income, we expect a strong bounce-back year to play out over the course of 2024. When bond yields are high, the income earned is often enough to offset most price fluctuations. In fact, for the 10-year Treasury to deliver a negative return in 2024, the yield would have to rise to 5.3 percent.
All else being equal, higher yields erode the present value of future earnings and hence lower stock market valuations (see our previous note for the maths behind this effect).
Why did the Treasury bond market crash in 2022 and 2023? Interest rates and the price of bonds have an inverse relationship. As interest rates go up, the market value (price) of bonds declines. When the Federal Reserve raises the federal funds rate, it can cause the bond market to crash.
We expect bond yields to decline in line with falling inflation and slower economic growth, but uncertainty about the Federal Reserve's policy moves will likely be a source of volatility. Nonetheless, we are optimistic that fixed income will deliver positive returns in 2024.
The disadvantages of bond funds include higher management fees, the uncertainty created with tax bills, and exposure to interest rate changes.
In line with the outlook from other investment providers, the firm is forecasting a 5.7% gain in 2024 for U.S. investment-grade bonds, versus 4.9% last year and 2.3% in 2022. (All figures are nominal.)
Key takeaways. Buying individual bonds can provide increased control and transparency, but typically requires a greater commitment of time and financial resources. Investing in bond funds can make it easier to achieve broad diversification with a lower dollar commitment, but offers less control.
Should you sell bonds when interest rates rise?
Unless you are set on holding your bonds until maturity despite the upcoming availability of more lucrative options, a looming interest rate hike should be a clear sell signal.
"Short-term bonds could be a safer bet in 2024, offering lower interest rate risk compared to long-term bonds," says Kovar. "They provide a relatively stable income stream with less exposure to market volatility."
Traditionally, the answer has been that bonds provide diversification and income. They zig when stocks zag, providing income for spending needs. In finance terms, bonds have “low correlation” levels to stocks, and adding them to a portfolio would help to reduce the overall portfolio risk.
A rising yield indicates falling demand for Treasury bonds, which means investors prefer higher-risk, higher-reward investments, while falling yield suggests the opposite.
one key risk to a bondholder is that the company may fail to make timely payments of interest or principal. If that happens, the company will default on its bonds. this “default risk” makes the creditworthiness of the company—that is, its ability to pay its debt obligations on time—an important concern to bondholders.
During a bear market environment, bonds are typically viewed as safe investments. That's because when stock prices fall, bond prices tend to rise. When a bear market goes hand in hand with a recession, it's typical to see bond prices increasing and yields falling just before the recession reaches its deepest point.
In a recession, investors often turn to bonds, particularly government bonds, as safer investments. The shift from stocks to bonds can increase bond prices, reduce portfolio volatility, and provide a predictable income. However, drawbacks include lower yield potential, default risks, and interest rate risks.
Sensitivity to Interest Rate Changes
Generally, when interest rates go up, the value of debt securities will go down. Because of this, you can lose money investing in any bond fund, including an ultra-short bond fund.
However, CDs, money market funds, government bonds, bond mutual funds and ETFs, and deferred fixed annuities, are all fixed-income investments that are considered less risky than stocks. In early 2024, U.S. Treasuries and some CDs offered yields in the 5% range.
For the quarter, the typical intermediate core bond fund gained 6.5%, while the typical ultrashort bond and short-term bond funds increased 1.8% and 3.4%, respectively.
What is the world's largest bond fund?
The largest active bond fund, the $131.6 billion Pimco Income PIMIX, gained 5.9% in the fourth quarter and 9.3% over the year—its best performance since 2012 and well above the 8.1% return on the average multisector bond fund.
Funds that focus on bonds with a specific maturity range generally say so in their name: Funds with "short-term" in their name typically invest in bonds that mature in 1 to 3 years; "intermediate-term" funds typically invest in bonds that will mature in 3 to 10 years; "long-term" indicates more than 10 years.
Opportunity cost. Having too much of your portfolio in government bonds could mean missing big gains in the stock market.
Treasuries are generally considered"risk-free" since the federal government guarantees them and has never (yet) defaulted. These government bonds are often best for investors seeking a safe haven for their money, particularly during volatile market periods. They offer high liquidity due to an active secondary market.
All bonds carry some degree of "credit risk," or the risk that the bond issuer may default on one or more payments before the bond reaches maturity. In the event of a default, you may lose some or all of the income you were entitled to, and even some or all of principal amount invested.
