What Will Higher Rates Do to the Kip 25 Bond Funds?

Defying almost all of the experts, interest rates continue to fall. At one point during the mid October stock-market pullback, the yield on the benchmark 10-year Treasury bond dipped below 2%, a full percentage point below where it stood at the start of 2014. But yields can’t fall below zero, and the lower they go the greater the likelihood that at some point they will turn up. The reversal is likely to occur in 2015, which is when the Federal Reserve has indicated it will begin raising the short-term rates it controls. Because bond prices move in the opposite direction of yields, holders of bonds and bond funds will almost certainly take a hit.

But how much pain would investors suffer? Specifically, we wondered how much might the bond funds in the Kiplinger 25 lose if yields were to rise one percentage point?

One way to answer the question is to look at a bond fund’s average duration and its yield. Duration is a measure of interest-rate sensitivity. A fund with an average duration of 3 years, for instance, would likely suffer a 3% drop in net asset value if rates were to rise by 1 percentage point (bond prices and interest rates tend to move in opposite directions). But the fund’s yield will offset that loss somewhat.

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Jeffrey Gundlach, lead manager of DoubleLine Total Return Bond (DLTNX), says that if you take a fund’s SEC yield and subtract the fund’s average duration, you’ll have “a good proxy” for a fund’s one-year total return should rates rise by 1 percentage point. That assumes that rates rise uniformly across the yield curve, the graph that measures what a bond pays across all of its maturities. With an SEC yield of 4.0% and a duration of 3.2 years, the DoubleLine fund should have a “positive rate of return,” says Gundlach.

So, too, would two other bond funds in the Kiplinger 25: Osterweis Strategic Income (OSTIX), which has a 4.3% yield and an average duration of 2.3 years, and Metropolitan West Unconstrained Bond (MWCRX), which yields 1.7% and has a duration of 1.2 years.

Based on this formula, the remaining four Kip 25 funds would likely suffer small losses. Vanguard Short-Term Investment Grade (VFSTX), which has a 1.5% yield and a duration of 2.4 years, would likely lose 1% on a total return basis. The three Fidelity bond funds on our list—Intermediate Municipal Income (FLTMX), New Markets Income (FNMIX) and Total Bond (FTBFX)—would each suffer a loss of 2% to 3%.

In truth, these calculations don’t do justice to the complexity of bond investing. Mark Sommer, manager of Intermediate Muni Income, says they don’t take into account the many other factors that affect a bond fund’s performance—from security and sector selection to how a fund is positioned along the yield curve.Money going into and out of a fund can complicate things, too. When short-term interest rates go up, says John Carlson, the manager of New Markets Income, which invests in emerging-markets debt, investors typically sell bonds from those parts of the world. This can wreak havoc with a fund’s returns if the manager is forced to sell holdings to cover redemptions. “So the impact of a rate rise on this fund would be negative,” he says. But unlike most other market watchers, Carlson doesn’t expect rates to rise soon. The global economic environment, he says, is “more deflationary” than inflationary.

Investors also move their money out of short-term bond funds and into money market funds when rates rise, says Greg Nassour, manager of Vanguard Short-Term Investment Grade. To gird against such an event, Nassour studied asset flows into and out of his fund during previous periods of rising rates and determined that he needs to keep 5% to 10% of the fund’s assets in cash to cover potential redemptions: “We are very well protected” against outflows, he says. Nassour is also adding ballast to the portfolio by buying IOUs that have been less volatile than other bonds.

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It’s difficult to say how a diversified bond fund will respond to a rate hike, says Ford O’Neil, who runs Fidelity Total Bond. “The two key drivers in our fund are not duration or yield,” he says. More important are the allocation among bond sectors and security selection. These days, he finds floating-rate bank loans, which are tied to short-term benchmarks and have interest rates that reset every 30 to 90 days, attractive. “We’re buying yields of 5% to 5.5% with no interest-rate risk exposure,” says O’Neil.

The managers of Metropolitan West Unconstrained Bond say it’s time to be defensive. The fund’s duration—1.2 years at last report—is “about as short as it can be,” says comanager Tad Rivelle, and still allow the managers to implement the fund’s mandate, which is to deliver positive long-term returns regardless of market conditions. He says he and his comanagers have focused on buying securities, including some non-agency mortgage bonds, with “fortress-like balance sheets” (those mortgage securities, which are not backed by the government, account for 30% of the fund’s assets). He calls them fortress-like because the risk of default is low given stricter lending regulations that have been in place for the past seven years. Borrowers who were “hopelessly under water, or who lost their jobs – they’re long gone,” says Rivelle. The fund is untethered to a benchmark, but it holds a variety of different bonds. Corporate bonds, mostly with investment-grade ratings (triple-B and higher), make up 20% of the fund’s assets. One-third of the fund is in asset-backed debt such as commercial-mortgage loans and student loans.

At Osterweis Strategic Income, managers Bradley Kane, Carl Kaufman and Simon Lee have followed a steady course in recent years: Junk bonds, mostly with maturities of four years or less, account for 83% of their fund’s assets. The combination of high interest coupons and short maturities reduces the fund’s vulnerability to rising rates. In any case, Kaufman says, he “can’t wait” for rates to rise because when the Fed finally moves, “people will act all surprised, and I want to be in a position where my fund doesn’t move much and I can pick up some bargains.”

The fund also selectively buys convertible bonds, which are hybrid investments with attributes of both stocks and bonds. Converts account for only 2% of the fund assets these days, less than the 6% position the fund had in these kinds of bonds in mid 2013, when we added Osterweis to the Kip 25. Until recently, bargains in this area were scant. But with the recent stock market pullback, Kaufman says, “we are starting to see opportunities. We have bought one convertible, and we have our eye on a few more.”