For most of the past 30 plus years bonds and bond mutual funds have done well in an environment of mostly falling interest rates. With the Federal Reserve's decision on Dec. 16 to raise rates, that trend has reversed itself. Many investors have not invested in a rising rate environment. What impact will the increase in interest rates have on investors in bond mutual funds?

Initial impact

There is an inverse relationship between bond prices and interest rates. All things being equal an increase in interest rates will cause the value of the underlying bond holdings in mutual funds to fall. A statistic called duration provides an indication as to the impact an increase or decrease in interest rates will have on the value of a bond mutual fund. Duration is expressed in years. For example, the Vanguard Total Bond Index (VBMFX) the largest bond fund in the country, has a duration of 5.72 years. This means that a 1% increase in interest rates would indicate that the underlying portfolio would decline in value by 5.72%. This a guide as the actual decline could likely vary a bit. (For more, see: How Retirees Should Approach Interest Rate Hikes.)

Factors Impacting Bond Duration

Bond duration measures the time period it will take for an investor to recover the cost of the bond and takes into account the present value of future cash flows including coupon payments and the return of capital. Bonds with a shorter time to maturity have a lower duration as will bonds with a higher coupon rate, all things being equal. Note that a bond mutual fund’s duration at any point is a snapshot in time and will vary. One major factor will be the turnover of bonds in the portfolio as some will mature, others will be sold and new bonds will be purchased by the fund’s managers.

Total Return

Returns for bond mutual funds are total returns which also include gains or losses on the underlying bonds held in the fund as well interest earned from the coupon payments of the underlying holdings in the fund. Total return figures quoted at places like Morningstar Inc. assume the reinvestment of fund distributions. What this means is that while an interest rate increase will initially have a negative impact on the fund’s value, some of this will be offset by the interest payments generated by the bonds held in the portfolio. (For more, see: Yield vs. Total Return: How They Differ and How to Use Them.)

How Will Bond Funds Fare?

It would be easy if factors like duration could predict what will happen to bonds and bond mutual funds now that the Fed has started on the path of rate increases with a high degree of certainty. The truth is that there are a lot of factors that will come into play.

The shape of the yield curve. With the rate hike, how will long-term interest rates react? Will the yield curve be relatively flat implying a lesser impact on longer-term rates? Will it steepen implying higher long-term rates? Only time will tell. Depending on how this plays out, bonds and bond funds with longer maturities and durations may or may not be severely impacted.

Market forces. Just like the price of individual stocks, the price of a bond is a function of market forces. The Fed’s actions impact short-term rates more than long-term rates and the supply of and demand for individual bonds will do more to determine the impact on bond mutual funds holding intermediate and longer-term bonds than will the Fed’s actions. (For more, see: The Effect of Fed Fund Rate Hikes on Your Bond Portfolio.)

Coupons matter longer term. The Wall Street Journal had Vanguard look at the impact of a hypothetical 25 basis point increase each quarter starting in January 2016 and going through July 2019. They found that holders of an intermediate bond fund would lose money in 2016 but would make money in the subsequent years. This makes sense as over time lower coupon bonds will be replaced with bonds sporting new higher coupons and longer-term returns for bond funds will tend towards the underlying coupon of the portfolio.

What to Expect

According to Charles Schwab Corp. before the Fed announced its rate hike, “This rate increase cycle has been one of the most directly telegraphed in history, and we've already seen a rise in intermediate- and longer-term rates in advance of the anticipated hike later this year. We expect the Federal Reserve to tighten short-term interest rates slowly in this cycle. A low and slow tightening cycle could lead to less volatility in each bond category.” (For more, see: Pros & Cons of Bond Funds vs. Bond ETFs.)

The Bottom Line

The interest rate increase by the Fed has been one of the most widely anticipated in history. Many financial advisors who use bond mutual funds and exchange-traded funds (ETFs) in clients' portfolios have been moving to shorter-duration funds over the past couple of years. While the short-term impact of a rate increase will likely be negative for bond fund holders, over time it could work to their advantage. (For more, see: Top 4 Ultrashort Bond Mutual Funds.)