Bond prices fall when interest rate rise. So when interest rate rises, the value of a bond or a bond portfolio falls. The fall in the value of bond portfolio depends on how much interest rate rises and on the maturity and the yield of the bond.
A bond’s interest rate sensitivity is measured by duration. Duration measures the approximate price changes when interest rates change by 1%, measured in years. For example, if the average duration of a bond portfolio is 3.5 years, then the value of the bond portfolio will fall 3.5% with a 1% rise in interest rates and vice versa. That means, the longer the duration of the bond portfolio, the more its price will drop when interest rate rises.
Short-term mutual funds versus long-term mutual funds
With the rise in interest rates in the near term, it’s advisable to invest in short-term mutual funds—funds with low duration and high credit quality. A fall in the value of short-term fixed income mutual funds will be less than long-term fixed income mutual funds.
Short-term mutual funds the Oppenheimer Limited-Term Government Fund – Class A (OPGVX) has a duration of 3.2 years while the Ivy Limited-Term Bond Fund – Class A (WLTAX) has a duration of 2.8 years. Both funds would be less affected by the rate hike than the others shown in the graph above. Floating-rate mutual funds such as the RidgeWorth Seix Floating Rate High-Income Fund – A Shares (SFRAX), with a duration of 0.5 years, and the Eaton Vance Floating Rate Fund – Class A (EVBLX) with a duration of 0.3 years, are also beneficial in a rising interest rate environment.
Meanwhile, the T. Rowe Price US Treasury Long-Term Fund (PRULX) has a duration of 15.6 years, the Wasatch-Hoisington U.S. Treasury Fund (WHOSX) has a duration of 19.7 years, and the Vanguard Total Bond Market Index Fund – Investor Shares (VBMFX) has a duration of 5.6 years. These could be sharply affected by a rate hike, especially if inflation begins rising. However, the impact on these funds could reduce if inflation remains benign for the medium term. The VBMFX invests in the bond issues of companies like Allergan PLC (AGN), American Airlines Group (AAL), and Oracle (ORCL).
Return on mutual funds
The WHOSX’s return fell 2.5% from October 28 to November 25, 2015. The return on short-term bond mutual fund OPGVX fell 0.4%, for the same period.
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