Bonds for all seasons

There’s no question that bonds are sensitive to rising rates. In such an environment, investors tend to replace lower-yielding bonds with newer, higher-yielding bonds, causing the prices of lower-yielding bonds to fall. But that doesn’t mean investors shouldn’t consider bond mutual funds as rates are rising, as is expected in coming months as the Federal Reserve moves to normalize monetary policy.

Bond funds
Because they always are investing and reinvesting new flows and sale proceeds, respectively, bond mutual funds provide a potential dual benefit: the opportunity to purchase bonds at lower prices (as rates rise, bond prices fall) and the potential to receive more income (as bond prices fall, yields rise).

Short- and intermediate-term bond funds
Because of their shorter duration relative to long-term bonds, short- and intermediate-term bonds – from 1- to less than 10-year maturities – may provide some protection against principal deterioration when rates are rising; they also offer the potential for more income as maturing lower-yielding bonds are replaced with new higher-yielding bonds.

Floating-rate bond funds
Because they invest in low-duration debt securities whose rates reset with the market, floating-rate bond funds may provide some protection against principal deterioration in a rising-rate market and provide more income as rates rise.

Multi-sector bond funds
Because they invest across asset classes with an emphasis on corporate credit, multi-sector bond funds tend to be less sensitive to rising rates while also offering the potential to participate in a growing economy that typically accompanies a rising-rate environment.

Municipal bond funds
In many ways, municipal bonds are more like corporate than Treasury bonds: they are backed by state and local governments and taxing authorities whose revenues generally are tied to the economy. So if rates are rising because the economy is growing, that is good for tax revenue. Muni bond funds usually are free from federal taxation, as well.1



Why bonds in a rising-rate environment?

Interest rates typically rise when the economy is strengthening—a factor that’s just as if not more important as the level of interest rates in regards to the performance of corporate and emerging-market bonds.

Here’s how such bonds have performed in the recovery’s past eight years: