A Research Surprise On Bond Funds

During the period from 1963 to 1981, when interest rates tripled, bond funds gained 116%. The Barclays Capital US Aggregate Bond Index produced a compounded cumulative return of 171% from its inception in 1976 to 1986, a period when interest rates jumped 3 percentage points.

Even if interest rates are rising, investors will bid up bond prices if bonds look like a better bet than other investment vehicles such as stocks and real estate. That logic applies to bond funds as well as to individual bonds. Also, interest income and reinvestment of interest income account for the bulk of bond fund returns, and that cash can offset the effect of decreasing bond prices. While interest rate swings do affect bond funds, the impact is more diluted with funds than with individual bonds. And though bond funds perform even better when interest rates are declining, the point is that long-term diversified bond funds tend to perform comparatively well in either environment.

Most analysts believe interest rates will head upward soon, after remaining at historic lows for the past two years. And that not only raises fears of falling bond prices but also the specter of rising inflation. Yet inflation may not pose as much of threat to bondholders as is generally believed, particularly if investors shift to bonds with shorter durations. For instance, from 1963 through 1981, Treasury bills earned an average rate of return of 6.29%, while inflation averaged 6.12%. Because short-term Treasuries have little sensitivity to interest rates, their prices also tend not to show the effects of rising rates.

Bonds in the real world don’t always behave in the ways predicted in the classroom. That’s partially because most investors buy bond funds rather than individual bonds, and partly because there is more to the story than an academic relationship between interest rates and prices. But it’s mostly because bonds are just one investment option among many, and investors make their choices based on the wider world of investment alternatives. The key is to understand that big picture and gauge which investment vehicles hold the most promise and what mix of investments best fits your needs.