How To Calculate Anticipated Bond Mutual Fund Losses From Rising Interest Rates

by: George Fisher

Do you know what the impact of a 1% rise in rates will have on each of your bond mutual funds?

Bonds funds have risks. One is interest rate risk and investors should know how it will impact each fund.

Different bond funds have different portfolio objectives and different interest rate risk.

A simple spreadsheet should bring bond fund interest rate risk into substantially better focus.

While the title may seem a bit obnoxious, in a rising interest rate environment, investors should anticipate a decline in the net asset value of each of their bond mutual funds. It is easy to calculate the risk to bond fund principal based on confidence in Morningstar calculations, and others, and a target level of interest rate increases.

Every bond fund investor should know a basic investing fact: After issuance, bond resale valuations in the marketplace move inversely with changes in interest rates, with the driving force being competitive rates of new issues of equal quality. As rates decrease, bond resale prices increase and as rates increase, bond resale prices decrease, and so does the NAV of bond funds.

As a simplistic example, a new bond with a maturity of 20 years is priced at $10,000 and a fixed coupon yield of 3.2%, or $320 a year. In a rising rate environment, if equal quality bonds of equal maturities were to offer 3.8%, or $380 a year in interest, investors would expect the 3.2% bond price to trade down so that the $320 in annual income would be competitive with the then-current new issue rate of a 3.8% yield. Likewise, if current rates were to fall to 2.8%, investors should expect the 3.2% bond to rise to $11,420 to offer the same 2.8% competitive yield.

Historically, bonds with longer maturities have a higher correlation with interest rate movements, both up and down.

Individual bonds have a maturity date whereby investor’s principal is set to be returned. Unlike their portfolios of individual bonds, the clear majority of bond mutual funds are open-ended and have no specific maturity date where principal is returned to fund investors. Maturing bond principal within a bond fund is reinvested in replacement bonds based on the fund’s stated strategy.

Like stock mutual funds, the usual means for investors to return bond fund's principal into cash is to sell at the then-current NAV. This is a very important difference with holding individual bonds vs. investing in bond mutual funds. While individual bonds and bond funds both are valued based on current competitive yields, individual bonds have a maturity date for principal repayment while bond mutual funds do not.

I had a client in our initial investment risk profile and goal-setting session admit she was very confused with bond mutual fund risk. After being “sold” on the “risk-free” nature of municipal bonds, she was quite upset to see her muni bond fund portfolio breakdown in the wake of then-well-respected analyst Meredith Whitney’s disastrous call on Dec 19, 2010. Whitney suggested the muni bond market was about to collapse, and investors heeded her warnings by fleeing with a $14 billion muni bond fund outflow from Dec 22, 2010 to Feb 2, 2011.

The stampede out of muni bonds caused losses for my client and others. Like many investors fearing Armageddon, she sold all her bond mutual funds, muni and otherwise, at a loss and has never forgotten the experience. Nor has she invested in any bond mutual funds since. The collapse in muni bonds did not happen as Whitney suggested. However, this story is very worthy of repeating. Below is a chart of Vanguard’s Intermediate-Term (MUTF:VWITX) and Long-Term (MUTF:VWLTX) Municipal Bond fund prices from Dec 1, 2011 before the Whitney call, and Feb 2, 2011, when the market is considered to have returned to “normal.”

As shown, at the height of the decline, VWLTX was down 5% in less than 6 weeks. So much for “safe” and “risk-free” muni bond funds. While this decline was not specifically interest rate change correlated, it demonstrates the potential volatility in bond funds. In fairness, VWLTX price peaked in Oct 2011 and was showing some weakness going into the Whitney call.

There is a financial calculation called the “duration” which estimates a specific bond portfolio’s correlation to interest rate movements. Morningstar offers the following definition of a fund’s average duration:

“Average Effective Duration: Average effective duration provides a measure of a fund’s interest-rate sensitivity. The longer a fund’s duration, the more sensitive the fund is to shifts in interest rates. The relationship among funds with different durations is straightforward: A fund with duration of 10 years is expected to be twice as volatile as a fund with a five-year duration. Duration also gives an indication of how a fund’s net asset value (NAV) will change as interest rates change. A fund with a five-year duration would be expected to lose 5% of its NAV if interest rates rose by 1 percentage point, or to gain 5% if interest rates fell by 1 percentage point. Morningstar surveys fund companies for this information.”

On Morningstar’s home fund page, a fund’s average maturity in years and average effective duration are listed, along with average credit rating of the portfolio. For example, using the two Vanguard funds, VWITX and VWLTX listed above, their avg. maturity is 5.7 and 6.8, and eff. duration is 5.4 and 6.9, respectively.

There are multiple flavors of bond mutual funds designed for different investment goals. These include tax-free income bond funds, international bond funds, diversified total bond funds, credit or issue type specific funds such as Treasury or Corporate Investment Grade, combined with maturity options of short-, intermediate- and long-term bond portfolios. Each of these will have unique trading characteristics based on their respective portfolios that will impact their respective effective duration calculations, and hence the movement of their NAV in a rising interest rate environment.

With a duration number and a forecast of interest rates in the future, investors can calculate the anticipated movement in the NAV of a specific fund.

Using RBC Wealth Management forecasts as of March 9, 2018, 10-yr Treasury rates are expected to increase from an average of 2.80% in the first quarter 2018 to 3.60% in the second quarter 2019. While this forecast is more aggressive than the Bloomberg Median consensus, it would indicate a rate rise of 80 basis points (bp), or 0.80%.

Some may argue this forecast is incorrect and only time will tell who was more accurate. With higher inflation expectations and economic growth in the 2.5% to 3.0%+ range, I plan on the RBC forecast as my guidepost. Supporting this more aggressive stance is an alternative estimate for an appropriate current Fed Fund rate as calculated by the Taylor Rule. As described on the Federal Reserve Bank of Atlanta website:

Taylor Rule Utility - The Taylor rule is an equation John Taylor introduced in a 1993 paper that prescribes a value for the federal funds rate—the short-term interest rate targeted by the Federal Open Market Committee (FOMC)—based on the values of inflation and economic slack such as the output gap or unemployment gap. Since 1993, alternative versions of Taylor's original equation have been used and called "simple (monetary) policy rules", "modified Taylor rules," or just "Taylor rules." We use the last term in this web page.

Below is the current chart of an appropriate Fed Fund rate per the Taylor Rule vs. the actual Fed Funds rate going back to 2000.

According to Atlanta Fed calculations, the 4th qtr. 2017 average Fed Fund rate was 1.2% vs. the Taylor Rule Prescription of 3.35%, and the average 1st qtr. Taylor Rule Prescription is higher at 3.70%. The Taylor Rule calculations support the opinion of more upward pressures on interest rates than downward pressure.

Then there is the issue of the yield curve, and its implications. The US Treasury offers a very revealing interest rate analysis tool on its website. The tool allows for direct comparisons of Treasury yield curves on two given dates. In addition, the tool allows for comparison of nominal and real rates. Below is the current nominal yield curve chart:

As rates move up and down, the spread between long and short rates will change. A “normal” curve shows a slope up and to the right; a “flat” yield curve shows no slope and an “inverted” yield curve shows a slope down and to the right. During times of economic growth, the yield curve is usually “normal,” during times of economic growth topping, the yield curve will move to a “flattening,” and as a predeterminate of a recession, the yield can become “inverted.” As shown above, the yield curve can be classified as “normal.”

Reviewing the yield curve during the recent past shows a continuation of the “normal” slope. Below is a chart comparing the yield curve on July 5, 2016 when 10-yr Treasury rates were at a low of 1.37% (green line) and on Dec 20, 2016 when 10-yr rates developed a short-term peak at 2.57% (blue line).

Lest we forget where we have come from, below is a long-term chart from of the 10-yr Treasury yield going back to the 1960s.

Using the RBC interest rate forecast, bond fund duration numbers offered by M*, and assuming the same slope of the yield curve, investors can calculate a potential reduction in bond mutual fund NAV if rates move up as forecast. Below is a table of several popular bond mutual funds with the current duration, current average maturity in years, SEC yield (12-month annualized previous 30-day yield), and the potential decline in NAV with an 80 bp rise in interest rates.

Vanguard - Total Bond (VTBIX), Corporate Long-term Corporate (VLTCX), Treasury Long-term (VUSTX), Treasury Intermediate-term (VFITX), Treasury Short-term (VFISX) and PIMCO - Income Fund (PONAX).

It seems, however, many investors are somewhat oblivious to the risk of bond mutual funds in times of rising rates. According to Lipper, in 2017, open-end stock and bond mutual funds and ETFs received a record influx of funds at $684.6 billion. Taxable bond was the leading inflow category group for the year with $388.8 billion, or 58% of all new investment capital committed to mutual funds and ETFs in 2017.

Last year was not the only year for massive inflows into bond mutual funds. Below is a 10-yr chart from Yardeni Research of the 13-week moving average of net weekly capital inflows for bond mutual funds. As shown, 2017 weekly bond fund inflow was fairly stable with a moving average in the $250-$300 billion range.

To personally manage potential interest rate risk, I have built a 7-yr ladder of mostly corporate investment grade date-specific Guggenheim BulletShares Bond ETFs. These ETFs are designed to hold bonds with maturities in a specific year. These ETFs liquidate at the end of the stated year and distribute the NAV proceeds. During the final year, the ETF builds its cash holdings in anticipation of liquidation as bonds' principal is repaid at their individual maturity dates.

For instance, the Guggenheim 2020 Corporate Bond ETF (BSCK) and the Guggenheim 2024 Corporate Bond ETF (BSCO) carry a Morningstar rating of 4-Star and 3-Star, SEC yields of 2.49% and 3.30%, average durations of 2.31 and 5.34, and average maturities of 2.4 yrs and 6.0 yrs, respectively. My overall goal is to annually move from the most recent year rung to the farthest out rung of the ladder until 30-yr Treasury yields arrive at a 5.0% level. At that time, I will re-evaluate my bond portfolio positions.

My strongest recommendation is for every bond fund investor to duplicate the simple spreadsheet above in order to laser-focus on the potential risk to principal. I added another column for my own evaluation – "Years of current yield to compensate for potential decline." While this reality may not materialize, it is important for investors to be fully cognizant of the potential consequences of a similar move in interest rates. Although this exercise may not alter your bond portfolio composition, it is vitally important for overall financial health to at least be aware of this potential impact.

Author's Note: Please review obligatory disclosures on my profile page.

Disclosure: I am/we are long BSCK, BSCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.