With yields on 10-year Treasurys up 47 basis points just since the start of June, some bond investors are wondering what the best avenues for fixed income exposure in a rising rate environment.
Foreign bonds, even those from AAA-rated developed market countries, are not providing much of sanctuary for wary bond investors. Rapid changes in risk appetite have prompted outflows from major junk bond ETFs, but investors face another important decision as rates rise: Stick with bond funds or opt for individual bonds? [No Country For Bond ETF Investors]
The conventional wisdom that many investors apply to the bond market is they can hold individual bonds to maturity and be buffered from the effects of rising rates. A spike in interest rates discounts the present value of the bond, but investors that hold until maturity get their principal back while earning the advertised rate of interest on the bond.
“Assume that market rates are 2% and we have a newly issued 10-year bond paying 2% interest with a par amount of $1,00. Discounting these coupons and the par amount at the market rate of 2% results in a price of $1,000. If market rates jump to 4% on the very next day after you buy this bond, we must now discount all future payments at 4%, resulting in a net present value of $836,” wrote Morningstar ETF Analyst Michael Rawson.
In the hypothetical scenario outlined by Rawson, an investor that opts to stick with the 2% bonds through maturity is making a significant sacrifice in terms of annual income. As Rawson notes, even if an investor sells the 2% bond to move into the 4% bond, the investor only earns 2% because of the incurred loss on the first bond.
Bond ETFs do not always keep all of their current holdings until maturity because of changes to an underlying index or fund redemptions. However, a bond ETF with an average effective duration of five years will be equally as sensitive to rising rates as an individual bond with the same duration, implying investors are not necessarily better off holding single bonds over bond funds if interest rates jump. [Investors Selling Bond ETFs as Rates Rise]