Oran Hall | Rising interest rates not good for bond funds

Have your ever wondered why unit prices of bond funds in collective investment schemes like unit trusts and mutual funds tend to fall although bonds are generally seen as safer than investment vehicles like stocks, which tend to be attractive more for capital gains than for income?

It has much to do with the relationship between changes in interest rates and the prices of bonds. There is an inverse relationship between them, meaning that they move in opposite directions. When interest rates increase, bond prices decline and vice versa. Because a bond fund is made up primarily of bonds, when bond prices change, the market values of the bonds change, and so do the unit values in a unit trust and the share value of a mutual fund.

Of particular importance is the fact that such values are reflective of the market prices of the securities at the time that the valuation of the fund is done, not just at the time that the securities are sold by the fund or when they mature. This approach gives a more accurate value of the fund and is fairer to both buyers and sellers.

The value of a bond fund is not only affected by the market prices of the securities which make up the fund but by the interest income received. Except in the case of distribution funds, which pay some income to investors, the interest earned is generally added to the fund and invested in the overall pool. While it may be useful, it may not always be enough to compensate for the loss in the capital value of the bonds.

The extent to which the value of the bonds in a portfolio declines depends on several factors.

First, the level of the change in interest rate matters. A big change has a greater effect on bond prices than a small change.

Second, the coupon rate – the stated interest rate on the bond – matters. The higher the coupon rate, the smaller the change in price, and the lower the coupon rate, the greater the price change.

Third, the term to maturity matters. The further the instrument is from maturity, the more significant the price change when interest rates change. From the foregoing, we can conclude that the prices of long-term low coupon bonds change the most, and the prices to short-term high coupon bonds change the least.

The extent to which the portfolio value and the value of individual units are affected depends on the mix of the portfolio, that is, the portion of the portfolio that is invested in each type of bond and the portion invested in long-term, medium-term, and short-term bonds. The funds with the highest proportion of long-term low coupon bonds are those most likely to experience the sharpest decline in their unit values.

Although a bond portfolio may have a good mix of bonds of varying maturities and coupon rates, it is possible that unit prices could take a long time to recover. If interest rates remain elevated for a long time, it could take time for the fund to recover although the prices of the individual bonds would increase as they move closer to maturity, some would mature and new ones could be added to the portfolio.

Bond prices may even take longer to recover than stock prices. Stock prices tend to fall when interest rates increase as investors re-align their portfolios to gain from the higher rates. Although lower stock prices generally have a more serious negative effect on fund performance than lower bond prices, stocks generally add much more to a portfolio when the stock market rallies.

The interest-bearing securities that are very short term – those in the money market funds – tend not to experience price declines, so money market funds should give positive returns as a matter of course – in the ideal world. Jamaica, it seems, is not a part of the ideal world for some money market unit values have declined in recent times. How can that be?

It seems that instruments given to price fluctuation have found their way into such funds sufficient to adversely affect unit prices. Should the Financial Services Commission require the filing of the actual asset mix of the funds periodically to protect investors?

When bond prices fall, they also affect other pooled investment funds. For example, mixed funds in the unit trusts and mutual funds which include bonds are affected, just not to the same degree as bond funds – which are not compelled to invest all of their money in bonds. Pension funds are also affected, as are the segregated funds linked to equity-linked life insurance policies.

Rising interest rates negatively affect the prices of bonds, and stocks, and thus the value of a wide range of pooled investment funds. They generate higher returns from new interest-bearing investments, but the interest the funds earn from fixed-income bonds already in the portfolio does not change. Falling interest rates have the opposite effects. Interest rates generate more income when they increase but cause the capital values of bonds to fall.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.finviser.jm@gmail.com