Bond Fund Vulnerabilities

Can bond funds protect you if interest rates rise?

Michael Batnick, research director at Ritholtz Wealth Management was in the hot seat on Bloomberg's ETFiQ show today. Michael is a great Twitter follow @michaelbatnick. He said one thing though that I would disagree with. When asked about the impact of rising rates on bond funds, he said that the yield would offset the declines in price.

The chart compares iShares Barclays Aggregate Bond Fund (AGG) and the iShares Barclays 20+ Yr Treas.Bond ETF (TLT). AGG has $54 billion and TLT has $6billion.

No one can know what interest rates will do but anyone concerned about rates, isn't focused on the 50 basis point move we have already had, they are worried about the ten year going to 4% or 5%. Again, without knowing what will happen, in just six months since they peaked, these funds are in a one and a half year hole in the case of AGG and a three year hole for TLT in terms of how long it will take to make back the losses in yield and the move up in yields has been small.

If rates do go much higher then many investment products will get hit very hard. As a rule of thumb, if interest rates go up 1%, a ten year note will drop about 8% in price. Bond funds with that sort of duration will do something similar price-wise but they have no par value to return to. Yields could go up by two percentage points resulting in a roughly 16% price decline perhaps requiring 3-4 years to get bailed out by fund payouts.

That doesn't have to be a terrible outcome but you need understand the possibility so that you have the correct expectations so that you don't do the wrong thing, like taking the loss and not waiting to get paid back.

I think the best path is funds with shorter durations to avoid interest rate risk, a small dose of alternatives that can serve as bond proxies in terms of volatility characteristics and total return, individual issues and a little bit maybe in interest rate hedged products.