ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

Avoiding the Interest Rate Freight Train with Individual Bonds

July 2nd, 2013

by Stephen J. Huxley, Jeremy Fletcher and Brent Burns

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

Since early May, the yield for the benchmark 10-year Treasury note has increased by nearly 100 basis points, highlighting the risk that bond fund investors face in their “safe” investments. For bond funds, rising rates mean that total return has to fight losses on the underlying portfolio. As a fund’s net asset value (NAV) declines, coupon interest may not be enough to overcome the price loss. Making the same fixed-income allocation to high-quality individual bonds instead and holding them to maturity is a superior strategy when rates rise. This strategy protects principal and avoids losses in a way that bond funds cannot.

A glimpse at interest rate risk

Interest rate risk in bond funds is like a freight train. You can see it coming long before it hits. The relationship between interest rates and bond fund total return is mathematically simple but not very intuitive. As rates rise, the prices of the underlying bonds in a bond fund fall. If prices fall by more than the coupon payments of the bonds in the portfolio, total return becomes negative.

Individual bonds, on the other hand, do not experience the same losses when held to maturity. Instead, high-quality individual bonds will deliver the scheduled cash flows from the coupons and return principal.

It is important to understand the fundamental distinction between an individual bond and a bond fund. Individual bonds represent legal obligations to pay coupon interest and return principal at maturity. That means coupon and principal payments are legally mandated when a bond is held to maturity. A bond fund has no such legal obligation. It is a pooled portfolio of bonds without the predictable characteristics offered by individual bonds. It is simply a mutual fund that happens to own bonds.

For the past 32 years, falling interest rates have masked that bond funds have an inherent weakness when rates rise. The last two months provided a sneak preview at the challenges faced by bond fund investors in periods of rising rates. Like a damsel tied to the tracks by a mustachioed silent film villain, bond fund investors sat helplessly as a small rise in interest rates crashed into their portfolios. Table 1 shows the losses experienced in May alone by the three largest bond funds – PIMCO Total Return, Vanguard Total Bond and Templeton Global Bond – which hold approximately $475 billion in assets. The average loss was slightly more than 2%, even though interest rates on the 10-year Treasury bond only increased from 1.66% to 2.16%. During June, the 10-year rose another 40 basis points, causing further damage. Portfolio turnover, lower credit quality and duration changes resulting from portfolio managers attempting to squeeze incremental yield out of the portfolio put additional price pressure on the portfolios as rates rose.

Table 1 – May losses in the three largest bond funds1

Fund

May Return

30 Day SEC Yield

Effective Duration

Average Maturity

Average Rating

Turnover

PIMCO Total Return

-2.15%

2.56%

4.77

6.09

Not Rated

380.0%

Vanguard Total Bond

-1.70%

1.60%

5.31

7.30

AA

80.0%

Templeton Global Bond

-2.19%

2.31%

1.59

2.48

BBB

47.7%


1. May returns quoted by Morningstar, Inc. as of 5/31/2013

Photo Credit: “The Perils of Pauline,” Theodore and Leopold Wharton, 1914

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