What’s next for bond funds after Fed decision

Relief washed over the bond market last week after the United States Federal Reserve decided to hold off on hiking interest rates. But many investors were left to wonder: Was it just a temporary reprieve?

The stakes are high for bond mutual funds, which are supposed to be the safe part of our portfolios. Investors have been fretting for years that interest rates are set to rise, something that would knock down bond prices.

And even though the Federal Reserve didn't raise its benchmark for short-term rates this past week, the majority of its policymaking committee still expects it to happen later this year.

Even so, bond funds can still be a shock absorber, offering some stability when the stock market goes on another of its dizzying drops, fund managers say. They're looking to offer reassurance following predictions for big losses for bonds. There's just one caveat that even the most optimistic manager acknowledges: Bond funds won't do as good a job as in prior years, because they're paying much less in interest.

"I don't think it's going to be Armageddon" when the Federal Reserve does hike interest rates, says Jim Kochan, chief fixed-income strategist for Wells Fargo Funds Management. "It's a healthy move away from zero."

When interest rates rise, demand for existing bonds falls because their yields suddenly look less attractive. That makes their prices drop.

To see what rising rates can do to bond mutual funds, look to 2013, when the yield on the 10-year Treasury nearly doubled in eight months. The average intermediate-term bond fund lost 1.4 per cent.

Investors can insulate themselves by buying individual bonds and holding them until maturity. That way, even if the market price drops for a bond, they won't necessarily feel it. But they would lose out on the extra income that a new, higher-yielding bond would have provided. Plus, most investors prefer a diversified fund portfolio of thousands of bonds.

The Federal Reserve controls interest rates for very short-term loans, ones that banks make to each other overnight. It has less control over longer-term interest rates.

A big factor influencing 10-year Treasury yields is where inflation and economic growth are heading, and neither looks all that strong. That should help limit the rise of longer-term rates, fund managers say. The largest category of bond funds focuses on those maturing in four to 10 years.

Keeping inflation low

Several factors are keeping inflation low, including the plummeting price of oil and the scarcity of pay raises for many workers. Global economic growth is also under pressure as China's gains slow sharply, while Europe and Japan struggle to kick-start theirs.

Add that together with the slow, steady pace that the Federal Reserve has promised for short-term interest rates, and fund managers expect longer-term interest rates to rise modestly and gradually.

In that scenario, bond funds could avoid losses. Their price will drop as interest rates rise, but the income they produce could help offset the declines. And the income could be reinvested in higher-yielding bonds.

Bond funds have historically helped give a sense of security when the stock market plummets. During the 2008 financial crisis, the largest category of stock funds lost 37.8 per cent, while many bond funds posted gains.

And among funds that lost money, bond funds generally had more modest losses than stock funds. The average intermediate-term bond fund had a loss of 4.7 per cent that year.

But bonds were producing much more income then. The 10-year Treasury yield is 2.15 per cent today, down from 4 per cent at the start of 2008, which means bond funds will likely provide less protection in the next steep decline for stocks.

Even if longer-term rates rise only modestly in coming years, they can still have quick jags up and down as the Federal Reserve returns rates to more 'normal' conditions. That means bond funds likely won't have the same placid returns as in prior years.

The Federal Reserve has kept short-term rates at their record low of nearly zero since 2008, and the last time it raised rates was nearly a decade ago. That means bond traders with several years' experience were barely in high school the last time the Fed hiked rates.

When choosing a bond fund, pay attention to its 'duration'. That number shows how sensitive a fund is to changes in interest rates.

The largest bond fund by assets has an average duration of 5.7 years, which roughly means that an immediate, one percentage point rise in interest rates would lead to a 5.7 per cent drop in price. Short-term bond funds will have shorter durations.