Many invests have put much of their assets in fixed income mutual funds over the past years. This is understandable given the turmoil in the stock markets, low interest rates on bank savings accounts, and perceived safety of bond funds. Investors use the bond funds primarily to gain additional income in their portfolios.
Investors could buy individual bonds to create their income portfolio. However, most people use mutual funds to due to the ease of investing and to obtain professional investment management. As the stock market rises and falls, the income earned on bond mutual funds may also increase or decrease. The market value of the bond fund assets will also rise and fall. As interest rates fall, the prices of bonds go up, and so shareholders have seen the market value of their funds increase.
Record Low Interest Rates and Coming Inflation
When markets are in turmoil, investors focus on the wide fluctuations in their stock market funds. Since they view their bond funds for income, they tend not to focus on the type of risks that exist with fixed income.
For the past 10 years, interest rate have dropped to the lowest levels not seen in many years. While bond fund investors have seen their level of income drop, this has been offset by an increase in market value. This is why the investors have the perception of safety in their bond funds.
Interest rate levels can and will change again. The level of spending at the federal, state, local and personal levels continues to rise. This will eventually give rise to an increase in inflation. When inflation rises, interest rates rise and the prices of bonds decrease. Fixed income investors will experience a drop in the market value of their bond mutual funds or bond portfolio. While higher interest rates may be welcome to many fixed income investors, these higher rates only apply to new money being added to funds. The existing fund assets will experience the drop in prices.
Effects on a Bond Mutual Fund and a Bond Portfolio
The effect of rising interest rates and falling bond prices will cause different reactions between bond mutual fund shareholders and those who have a portfolio of bonds. The investors who bought individual bonds will merely hold the bonds until they mature. At that point they will receive the full face value of the bonds, and will not experience any loss of principle.
Investors in bond mutual funds have a different issue, one that is often misunderstood. Bond mutual funds never mature. The fund manager is continuously reinvesting the proceeds from maturing bonds into new bonds. So, bond fund shareholders must decide to either continue holding the fund, or sell their shares at some point and incur the possible loss of principle.
How to Protect Against Rising Interest Rates
The effects of inflation will have the greatest effect on long term (15 – 30 years) bonds and bond funds. Shorter term bonds and funds will be affected, but to a much lesser degree than long term securities. Bond fund shareholders need to know the average term of the bonds in their funds. If the funds hold long term bonds, it would be wise for such investors to consider transferring their assets from these funds to a fund with shorter term maturities, such as a 10 year or short term bond mutual fund. This should be done now while bond prices are still high. While the short term bond funds will yield a bit less interest, they will be much safer in a rising interest rate environment.