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"What Happened to my Bond Funds?"


Prior to November 8, most experts predicted a Trump election would initially knock stocks off their perch while bonds (and gold) would likely hold their own. In fact, we've seen the exact opposite thus far. So it's understandable that folks with more “conservative” portfolios are wondering what in the world happened to their bond funds.

Interest rates took the elevator to the 2nd or 3rd floor last week and a move like that always causes a corresponding reaction in bond prices. Here’s my chicken-scratch illustration of the Bond Teeter-Totter.

There's an inverse relationship between bond prices and interest rates. When interest rates fall, bond prices rise (to keep yields in line with falling rates). Similarly, when interest rates rise as they did last week, bond prices correspondingly fall. It's simply two sides of a teeter-totter and a bond's yield is just the annual interest you receive from it divided by its price.

A change in interest rates has a much bigger impact on bonds with long term maturities vs. those maturing in just a year or two. For example, a rise in rates will hurt a 30-year US treasury bond far more than a high quality 3-year corporate bond.

Bond funds use a calculation called duration to measure this sensitivity to rates. If interest rates rise 1%, a bond fund with a duration of 9.2 would decline in price by about 9.2%. Yes, you read that right. (Note: if you hold a solvent invididual bond to maturity, the full principal will be paid out to you and interim fluctuations in price won't matter.)

In SecondHalf managed portfolios, most bond fund durations in client retirement accounts currently range between about 1.8 to 2.6. So pretty conservatively positioned. For client taxable accounts, durations for tax-free municipal bond funds currently range around 5.2 to 7.0. So those funds will be more sensitive to interest rate changes.

The Wall Street Journal published a May 2016 article The World's Safest Bonds Are Actually Wild Risks that has an eye-opening calculator you can test drive. Move the interest rate slider up or down and see the impact on prices (as of May 2016) of various global government bonds.

US interest rates have been in long-term decline since the 1980s, which is why bonds have been such great performers over that time. In the more recent low rate environment, investors have cluelessly bid-up the prices of longer term income securities to far beyond what they'd be in a more "normal" economic environment. Those who've indiscriminately done so are in for a rude wake-up call once we get a sustained rise in rates.

Finally, it's important to note that "bonds" is not actually a homogenous group. There are US treasuries, mortgage bonds, corporates, high yield (“junk”), non-US bonds (developed and emerging markets), municipal bonds, floating rate loans, and so on. Interest rate changes will have a differing impact on the various types of bonds.