Will Short-Term Bond Funds Lose Value When the Fed Raises Rates?

What We Can Learn From the Lessons of 1994

USA, California, San Francisco, Federal Reserve Bank, low angle view with wide-angle lens
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The federal funds rate—the short-term interest rate controlled by the U.S. Federal Reserve—hovered near zero for so long that investors tended to forget that the Fed used to change this rate several times each calendar year.

The rate was .50 at the end of 2016 and it started rising from there to reach 1.25 percent in 2017. The Federal Reserve indicated that it would bump the rate up again to 1.5 percent in 2017, but that hadn't happened as of early November.

The Fed also mentioned that we might expect a rate of 2 percent in 2018 and as much as 3 percent by the time 2019 arrives. 

Although the exact timing is unknown, one thing is fairly certain: the Fed will continue to raise rates at various points sometime in the future. Bond investors will face a new challenge as this occurs: the potential for price weakness in short-term bond funds.

The Old Environment 

This will represent an important change from the environment that was in place beginning with the 2008 financial crisis and shortly thereafter. The low level of the fed funds rate at that time—and investors’ knowledge that rates would stay low for a multi-year period—enabled short-term bonds to deliver steady returns even during the bond market sell-off of 2013.

The calendar year returns for the Vanguard Short-Term Bond ETF (BSV) in the period from 2008 through 2013 plummeted from 8.5 percent in 2008 down to .15 percent in 2013.

These returns aren’t spectacular, but they certainly fulfilled investors’ expectations for steady performance with low volatility. As the Fed begins raising rates again, however, the environment for short-term debt might not be quite so positive, depending on how high they go. But just how bad could it get?

The Lessons of 1994

The current standard for poor bond market performance is 1994 when the Barclays Aggregate Bond Index fell 2.92 percent—its worst return in the past 34 years. The cause of this downturn was the Fed’s decision to raise interest rates aggressively from 3 percent at the start of the year to 5.5 percent by year's end. This move incorporated six rate hikes, including three quarter-point moves, two half-point increases, and one three-quarter point move to close out the cycle on November 15.

This represented a surprisingly aggressive strategy that caught investors off guard and eventually contributed to a collapse in the prices of complex derivatives owned by some mutual funds and other large investors. The losses in these derivatives were the key factor behind Orange Country’s infamous bankruptcy in December 1994.

For individual investors, the bond-market volatility played out in the form of sizeable losses in bond funds. Perhaps most surprising were the negative returns for short-term bond funds. Investors typically own short-term bond funds as a low-risk vehicle to preserve their principal, so losses in this segment tend to be more upsetting than a downturn in investments such as stock funds where volatility can be expected.

The Wall St. Journal reported the following in its February 1, 2010, article Short-Term Bonds Carry Risk When Rates Rise:

“In 1994, when the Fed launched an aggressive series of rate increases, some 120 funds suffered (calendar) quarter losses topping 2 percent. Many of them were municipal-bond funds hammered by the bankruptcy of Orange County, Calif.”

Separately, the financial planning firm Cambridge Connection LLC reported that:

“In 1994 … the increase in short-term interest rates saw a drop of 4.75 percent on average in the (net asset value) of short-term bond funds. For many individuals, this meant a loss of capital that they were not prepared to suffer.”

Why were short-term bonds hit so hard in 1994, but not in 2013? The answer is that Fed policy is the primary factor driving the returns of short-term bonds, meaning that they tend to hold up much better than long-term debt when the Fed is expected to keep rates low as was the case in 2013.

In contrast, the aggressive Fed action in 1994 set the stage for larger losses in short-term bond funds.

Could 1994 Happen Again?

In some ways, the lessons of 1994 are still relevant today. When investors begin to focus on the potential for Fed rate hikes, short-term bonds will almost certainly begin to experience lower returns and—depending on the type of fund—greater volatility than they have in years past. In all likelihood, this will become more of an issue for the market as the rate increases over the next couple of years, if indeed it does. 

Having said this, there are two important reasons why investors don’t need to worry about a repeat of 1994 as the Fed begins raising rates. First, the Fed tends to telegraph its moves much more effectively and reliably now than it did 20-plus years ago. It’s highly unlikely that today’s Fed would choose to disrupt the markets via a violent, surprising series of rate increases as it did in 1994.

Second, the potential impact of derivatives is more contained now than it was in 1994 due to tighter regulations on financial institutions.

Both of these factors indicate an era of paltry returns for short-term bond funds, but not the type of downturn that occurred in 1994.

The Potential Benefit of Fed Rate Hikes

The impact won’t be all bad as the Fed raises rates. As the fed funds rate goes up, so, too, will the yields on short-term bonds funds. But keep in mind that this process doesn’t happen overnight. It occurs gradually over time as funds’ holdings mature and portfolio managers replace them with newer, higher-yielding securities. Higher yields, in turn, allow investors to earn more income from their portfolios. Higher yields also offset some of the losses that occur in bond prices, which can help stabilize total returns.

The Bottom Line

The losses in short-term bond funds aren’t likely to be severe when and if the Fed raises interest rates again, and they're even more unlikely to match those registered in 1994. However, it’s also probable that short-term bond funds will become less reliable in terms of their ability to keep your money safe going forward. If preservation of principal is your top priority, it’s time to begin thinking about alternatives