Bond fund's next frontier

October 3, 2015 09:00 AM

“…investors are led to believe that the very name ‘bond’ must carry some special assurance against loss. This attitude is basically unsound, and on frequent occasions is responsible for serious mistakes and loss.”

– Benjamin Graham, Security Analysis


Fixed Income: The very moniker conjures up the perception of safety and stability. An investment that provides both a scheduled payout—however large, small or infrequent—and returns your initial investment seems like a sure winner. 

But the apparent safety of investing in bonds dissipates quickly upon further inspection. “Low risk” bonds have provided a safe haven for a generation of mutual fund investors. However, as interest rates continue toward historic lows, questions are beginning to mount about how these funds might perform in the wake of a new normal.

Exactly how much has the decline in interest rates benefited performance for bond funds during the last quarter century? And what are the implications of losing this benefit going forward?

“Yields and returns,” (below) illustrates the relationship of the Fidelity Spartan Long Term Treasury Bond Index Fund (FLBAX, current duration: 17.53 years) against the prevailing 20-year yield over the past five years, demonstrating how changes in the 20-year yield affect corresponding changes in the value of the fund.

The value of a bond held at a given point in time is highly dependent on the difference between the inherent rate of the bond and the prevailing rates offered at that time. As interest rates increase above the rate a bond pays, the value of that bond decreases; the opposite is true as rates decrease. This interest rate sensitivity is known as duration.

A study of the timeframe between March and June of 2012 shows that during this period the 20-year yields decreased from 3.13% to 2.13%. During the same period, the value of the FLBAX—which based upon its duration should increase approximately 17.53%—rose from 10.80 to 12.66, a 17.22% increase. It’s important to examine the implications this can have for the investor. “Across the curve,” (below)  shows historical interest rate movements since 1978.

It’s readily apparent from the chart that interest rates have steadily declined for the past 30 years. Given the inverse relationship between bond yields and bond fund prices, these funds have been riding a three-decade bull market. But what happens if that ride ends? 

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About the Author

Rob Matthews develops technical trading strategies as Research Director for Covenant Capital Management.

Josh Ireland performs statistical research as head of Covenant’s Analytics Department.