Finding the best bond funds for rising interest rates and inflation can be easy if you know what types of funds to look for. When interest rates are on the rise and seem destined to continue in that trend, learning how to invest for higher rates is a smart move.
For decades, bond prices were rising for the most part, which was positive for returns on bond mutual funds. But when interest rates climb, the bull market for bonds typically comes to an end.
That doesn't mean bond funds don't have a place in your portfolio. And it doesn't mean you should sell your bond funds just because the market is changing. You simply need to find the best bond funds when rates are rising. You also should learn which bond funds do best against inflation.
Learn the basics on which funds perform best and which funds perform worst before and during higher interest rates and inflation.
How Are Bonds Related to Interest Rates and Inflation?
The reasons that bonds are sensitive to interest rates and inflation are often explained in a way that's tough to understand, but it doesn't have to be that difficult. Here are the main points you need to know to help you build the best portfolio of mutual funds:
- The Federal Reserve Board raises interest rates when it fears that inflation will result from a growing economy. It also lowers rates to fight deflation, a potential recession, or both.
- The higher rate is called the "federal funds rate." It is charged to banks by the Federal Reserve to increase the costs of borrowing for banks, which indirectly pushes them to pass on these costs to their customers. In other words, the interest charged on most loan types will increase after the Fed raises its rates.
- Bonds are essentially loans. If prevailing interest rates on loans, including bonds, are rising, bond investors tend to demand the higher-yielding bonds to make more money on their bond investments.
- When bond investors want newer bonds that pay higher interest, the older bonds that paid lower rates become less attractive to investors. Why buy a bond that pays 6% when you can get a similar bond that pays 6.5%? When bond investors want to sell their older bonds that pay lower rates, they are forced to sell the bond for a lower price than they bought it for. That's because the investor who is buying it will want a discount for taking on the lower interest rate.
Bond prices move in the opposite direction of interest rates because of the impact that new rates have on the old bonds. When rates are rising, new bond yields are higher and more attractive to investors. On the other hand, the old bonds with lower yields are less attractive, which forces prices lower.
The main thing to remember is that rising interest rates equals lower bond prices.
How Do Rising Rates Affect Bonds?
There's one more key point to know about the relationship between bond prices and interest rates. Bonds with longer maturities are more sensitive to interest rates than bonds with shorter ones. For instance, if interest rates are rising, who wants to own the bonds that are paying lower rates for even longer periods of time? The longer the maturity, the greater the interest-rate risk.
Let's take a look at certificates of deposit (CDs). When the new CDs come out with higher yields, the CD investor wants to replace the old with the new. Savvy CD investors buy CDs with shorter maturities (one year or less) if they expect rates to keep rising over the next year. Bond investing when rates are rising follows the same logic.
Best Bond Funds for Rising Interest Rates and Inflation
Now you know the basics about bonds and interest rates. Here are some specific bond fund types that can do better than others when rates are rising:
- Short-term bonds: Rising interest rates make prices of bonds go down. But the longer the maturity, the further prices will fall. And the opposite is also true: Bonds of shorter maturities do better than those with longer maturities when interest rates are rising because of their prices. Keep in mind that "doing better" may still mean falling prices; however, the decline is often less severe. A few bond funds that work well include PIMCO Low Duration D (PTLDX) and Vanguard Short-Term Bond Index (VBISX).
- Intermediate-term bonds: Although the maturities are longer with these funds, no one really knows what interest rates and inflation will do. Intermediate-term bond funds can provide a good option if you choose not to predict what the bond market will do in the short term. For instance, even the best fund managers thought inflation (and lower bond prices) would return in 2011. That would have brought on higher interest rates and made short-term bonds more attractive. But those fund managers were wrong. They lost to index funds, such as Vanguard Intermediate-Term Bond Index (VBIIX), which beat 99% of all other intermediate-term bond funds in 2011. Bond funds generally didn't fall in price for a full year until 2013. You can also try a more diversified approach with a total bond market index exchange-traded fund (ETF), such as iShares Barclay's Aggregate Bond (AGG).
- Inflation-protected bonds: These are also known as "Treasury Inflation-Protected Securities" (TIPS). These bond funds can do well just before and during inflationary environments, which often coincide with rising interest rates and growing economies. One standout fund for TIPS is Vanguard Inflation-Protected Securities Fund (VIPSX).
The best bond funds for rising rates are not guarantees of positive returns in that kind of economy, but these types of bond funds do have lower interest-rate risk than most other types of bond funds.
Frequently Asked Questions (FAQs)
What is a bond?
A bond is a security that usually pays a fixed interest rate. It represents a loan to a government entity or a corporation. While you own a bond, you receive interest payments. When the bond matures, you receive the principal amount back. Some bonds are considered fairly secure, but there is a risk of default that varies, depending on the type and grade of the bond. If the bond issuer has a poor credit rating, there is a higher risk of default.
What is a bond fund?
A bond fund is a type of investment vehicle. Investor funds are pooled together and buy a range of bonds. Unlike individual bonds, bond funds don't have maturity dates. Bond funds usually focus on one type of bond, such as corporate bonds or government bonds.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.