As interest rates are going up, the question many investors are asking is, "How much will my bond holdings, or my bond-oriented mutual fund, depreciate?" As a general rule, for every 1% increase in interest rates, a bond will depreciate its duration in percentage points. For example, if a bond has 10 years left to maturity and rates go up 2%, then the bond's value will depreciate 20%. This makes perfect sense as the bond will have to provide an additional 2%/year and with 10 years to maturity, the price component of the "yield-to-maturity" formula will need to kick in an additional 20%.
If an investor is planning on holding the bond to maturity, assuming there is no default, the bond will eventually return 100% of its par value to the investor. However, the interest paid by the bond will be below-market rates. The problem arises if the investor has to liquidate the position. Then he or she can expect to receive somewhere in the ballpark of the following:
Par value * [(Current interest rate - par value interest rate) * remaining duration] = market value of the bond
Because rates were brought down to rock-bottom levels, rising rates could possibly impact Main St. investors utilizing bond funds in a few different ways.
Bond Mutual Fund Investors
1. Most mutual funds do not have the luxury of holding bonds to maturity as they have a target maturity that they have to maintain. So, as bonds reach a certain time to maturity, the bond fund will have to sell and reinvest in new issues. If rates are higher when they sell the bonds than when the bonds were purchased, the fund will realize a loss on the position.
2. If there is a "run on a fund", the bond manager will have to liquidate positions to meet redemptions. Ironically, rising interest rates will greatly increase the odds of fund redemptions thus creating a vicious cycle.
3. Finally, there is the possibility that fund investors who bought into bond mutual funds in recent years may experience losses but still be on the hook for embedded gains in the fund. As a mutual fund investor, every shareholder is ultimately a limited partner in the fund. And every limited partner is responsible for realized gains in the fund or partnership. So it is feasible, if not likely, that a recent investor in a bond fund may see the value of their investment fall in value while still being stuck with a tax liability.
I read somewhere that in the 1970's, the last time yields went up consistently, there were only five bond-oriented mutual funds in existance. So, it goes without saying, the gross majority of mutual fund investors have not lived through a period of rising rates while owning bond funds. Q1 may serve as a wake-up call that bond fund investors ought to look for an alternative.