Remember that when you buy a bond mutual fund, there are typically two components that determine your total return. The first is the nominal yield (also called a "current yield" or "SEC yield"). This is the average yield based on the current value of the underlying assets, typically a group of corporate or Treasury bonds. The second component of the return is based on the change in the average of the market value of all the individual bonds in the bond fund. The price of almost all bonds goes down as interest rates go up, and goes up when interest rates go down. The reason that investors in bond funds have generally done well in recent years has not been the result of high current yields on their investments. Indeed, most bond yields, especially government bond yields, have been very low in recent years, with some recently hovering near all-time record lows.
The reason that investors have seen such solid and steady investment returns in recent years is mostly a result of declining interest rates. These in turn were a result of Federal Reserve and Treasury manipulation of interest rates in response to economic weakness (and are primarily responsible for the many economic bubbles the U.S. has experienced and is currently experiencing). However, eventually, interest rates will hit a bottom, and may rise sharply in the months and years ahead. In fact, the extreme financial indebtedness of U.S. consumers and the government warrants a significantly higher level of interest rates that reflect the increased risk of government default and potential for a dollar collapse.
That is not to say that bonds or bond funds don't deserve a place in investors' portfolios. For most they probably do. The types of bonds an investor owns and the percentage they should make up of an investment portfolio depends on personal circumstances and individual risk tolerance. The point is simply to be aware of the risks of higher interest rates and recognize what will happen to the price of a bond or bond fund if and when rates rise. For some bond funds, the risk from higher interest rates is very small, while for other bonds funds, investors will see sharp losses from higher interest rates.
When observing bond fund volatility, it's clear that short-term bonds are going to be less sensitive compared to longer-term bonds. (A short-term bond is usually defined as having a maturity of less than 2 years; an intermediate-term bond matures in 2-10 years and long-term bonds typically mature in 10-30 years.)
Short-term bonds will react less to movements in interest rates compared to longer-term bonds. For example, an investor who owns a two-year (coupon) Treasury bond, at current interest rates, would see the value fall almost 2% for a 1% increase in interest rates. For a ten-year Treasury bond, a one-percentage increase at current interest rates would result in about an 8% decline in the value of that bond. (For the same bond, a two-percentage point increase would result in a 16% decline, and so forth. The value of the same bond would also rise by about 8% and 16% if interest rates declined by 1% and 2%, respectively.)
Since bond funds are just a collection of individual bonds there should be a way to measure the interest rate risk for those as well. And there is. It's called duration. The duration of a bond fund is the percentage that the market value of the mutual fund changes for every 1% change in interest rates. Again, the value will usually go up with lower interest rates, and go down with higher interest rates. For example, looking at a particular bond fund, American Funds' Bond Fund of America, the average duration is 4.4 years. That tells me that if interest rates immediately increased by 1%, I can expect the value of this specific bond fund to decrease by about 4.4%. Note that this does not factor in the higher interest that a fund generates as interest rates increase. Thus, in this way, even though the value of a bond mutual bond fund typically declines with higher interest rates, the higher interest payments offset the bond value's decline to some extent.
Taking another example, Vanguard's Short-term bond fund's duration is currently just 2.6 years, so a 1% increase in rates would result in just a 2.6% decline in the value of the fund. Conversely, Vanguard Long-term Bond Index fund's duration is 11.6 years, resulting in a significant 11.6% decline in value if interest rates increase by 1%.
As with all investments, the tradeoff between risk and return is what all bond fund investors face. While the Vanguard short-term bond fund is much less volatile, the current yield is just 1.6%, so an investor is paid little for the security of a "low-risk" bond fund. At the same time, investors in Vanguard's long-term bond fund, who currently receive a 5.0% yield, could easily see a 10% or 20% decline in the value of their bond fund with a sharp increase in interest rates.
Although interest-rate risk may be the largest risk for bond fund holders, there are other factors that bond fund investors also need to be aware of: the average credit quality of the individual bonds, the leverage used (in some cases), and the industry concentrations. During the credit problems in the last two years, many bondholders who thought they were holding "safe" bond funds, many of which included risky mortgage-backed securities, resulted in sharp losses for their supposedly safe bond funds.
Just like with stock mutual funds, bond fund holders need to understand the risks of their investments. While bonds can make sense for many investors of all ages, the strong performance of bonds during the past decade, has lulled some bond fund holders into believing that bond funds are riskless investments, that never lose money. But there have been many instances of specific bond mutual funds losing 20%, 30% or more in short periods of time. For example, during the past two years, as economic conditions deteriorated, some bond mutual funds that invested in mortgage-backed securities, resulted in sharp losses for many bond fund investors. Bond fund holders need to understand what they're buying or thinking of buying. In the follow-up to this article I'll discuss some other things to think about when investing in a low interest rate environment.