A question about bond funds and interest rates

Hello

can someone please help me with the following question please.

Lets say interest base rates are 3% and I buy a bond fund paying 4%. Now if base interest rates go up to 4% and new issue bonds pay 5% interest. My existing bonds face value on the open market would go down (e.g. why would anyone buy my 4% bond when they can buy a new bond paying 5%, unless I offer a discount for my bond, below par).

Now lets consider a bond found run by a pension found where the bonds they hold are split over various maturity 1-5 years, 5-10 years, over 10 years.
Lets say I decide to buy into this bond fund by allocating part of my regular pension contributions to this bond fund.

Now my question is 'in general' what happens if interest rates in the open market increase, as far as I can see two things may happen

1) People invested in equities (shares) fear higher cost to the companies for which they hold shares, decide to sell and buy bonds as the interest rate on offer is now more attractive. This supply and demand should in theory push up bond prices (including the bonds I hold in the pension).

2) However, interest rate rise hurts existing bonds and therefore this should in theory bring bond prices down (including my pension fund bonds).

The above is my understanding (not necessarily correct), therefore can someone help me understand the likely impact (I am not asking for finical advice as it were) if I buy into bond fund now, and interest rates rise over the next several months?

Thanks all in advance
EB

Comments

  • Your analysis is correct.

    There are a couple of things I would add.

    1. The likely impact will be based on how much extra interest rates go up compared with what the market expects.
    2. The price of the bond may increase or decrease depending on credit risk and rising interest rates may reflect greater risk of bond defaults at the margin.

    What you are probably most interested in with regard to your question is the duration of the bonds in the bond funds. If the duration is long then the bond fund price is going to fall far further than if the duration of the bonds in the fund is short. That is, if the bonds in the bond fund have say 15 years to maturity the impact of the rise from 3% to 4% in your example is large whereas if the duration is say 2 years, you will suffer a bit of pain for 2 years but then the bond fund can replace the bond with something with a higher yield.

    Finally, just to confuse if the very large wall of money that has gone into equities starts coming out if the market falls and the money requires a home, the wall of money going into bonds instead may be so large that bond fund prices don't fall at all as investors will be willing to accept a lower return on their capital for the safe security of their money.


    At the moment with interest rates so low the amount some bond funds are moving is greater than the underlying yield so it may be very easy to lose money investing in bonds if you get your timing wrong. Take a look at the chart for SLXX and you will see what I mean.

    Also, bond funds with invested in bonds paying 1% interest are going to be more price sensitive than bond funds invested in bonds paying say 5%, because say a 1% rise in interest rates will halve the value of a bond fund invested in bonds paying 1%, whilst the one paying 5% will fall less. (well not halve as the maths doesn't quite work that way but I trust everyone appreciates what I'm getting at)


    Specifically if you are really concerned about rising interest rates as a result of inflation (as I am) then you will want to be focussed on bonds and bond funds with short duration. Regrettably what you are going to find it that so are zillions of other investors and they don't look particuarly cheap imho as the time to buy these was the day Pfizer announced good efficacy for their vaccine (or before that but you would have had to have been brave)
  • Thanks very much for taking the time to reply to my questions
  • The bond funds would generally be hedged against interest rate movements usually and also the credit risk of individual firms comprising the fund (if CDS are available etc).
  • AJR

    I'm very interested in investing in a bond fund that is hedged against interest rate movements and I wonder if you could point me in the right direction. I used to own AEFS which was a floating rate fund but sadly this got wound up about a year ago in order to close the discount to NAV. I've found nothing to replace it with
  • This is the picture as I see it for most of the investors on the ORB. The biggest risk we generally face is credit default risk, that is why the coupon is so much higher than gilts. In terms of interest rates, we have the very short term rate, controlled by the Bank Of England, and Long term rates (Gilt Yields), determined by market forces (and to a lesser degree the Bank of England, by policy and buying large amounts of Gilts). Gilt yields are risen very substaintly, without the same impact on ORB yields (the credit spreads improved). The other factor is inflation, you can buy inflation linked bonds. Finnally, some of the PIBS are reset every n years over a gilt term yield.
  • Hi JammyDodger, unfortunately it's not something I have looked into much detail as I tend the DIY approach and just buy my own retail bonds. I would say to read the prospectus/termsheet of the funds and look at the holdings to see if you can deduce what they do in terms of hedging.
  • It's a question a lot of us must be pondering. I hadn't considered using a bond fund that hedges interest rate rises and I wouldn't expect funds to do this as a matter of course. There will be a cost to this on top of the fund charges which could eat into returns. I wonder how far rates can actually rise as it would cause financial problems for millions of people who have got used to the current rates (I can remember paying 12% on my mortgage rather than 1.2%) However a quick google search suggests there may be ETFs that hedge at low cost. Inflation is my worry although seems there may be an incentive for central banks to allow higher inflation without immediately raising rates. Index linked bonds will help here although they still have negative real rates. Going further afield and away from fixed interest, renewable energy funds have fallen recently by 10-20% (wind, solar etc.) and now yield between 5% and 7% and I decided to put some money here rather than corporate bonds. The income is fairly predictable and offers some inflation protection although capital values could fall further (or rise as is my hope!) I also looked at some bond investment trusts that historically had traded above their net asset value and are now on discounts of up to 10%. Again my hope is that the discount will close or at least not get wider. Maybe the bad news of possibly rising rates is factored in. MGCI was one such fund which has relatively short duration and mainly investment grade bonds. HDIV was another contender although that seems to have closed the discount in the last couple of weeks
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