How rising interest rates affect bond funds

The low inflation of the last 4 decades appears to be over, and a new era of sustained inflationary pressures and rising bond yields may be upon us. Those of us who weren’t around for the high-inflation, low-growth environment of the 1970s will likely see the loss of purchasing power in our portfolios for the first time.

So now may be the perfect time to bone up on how rising interest rates are affecting bond funds. It’s also a good time to emphasize a key point: Over the long haul, higher yields mean more income from the fixed income portion of a portfolio.

Rates rising rapidly

After an extended period when bond yields generally trended lower, it’s worth looking at how much the U.S. Treasury yield curve has changed since the Federal Reserve (Fed) started raising rates after inflation began to spike in 2021.

The federal funds target rate now stands at a range of 4.25% to 4.50%—up from a range of 0.00% to 0.25% before the Fed started increasing rates. The Fed’s most recent rate hike, on December 14, 2022, was 50 basis points, and the central bank has signaled it plans to continue to raise the target rate until inflation is reined in. (A basis point is one-hundredth of a percentage point.)

The effects of the Fed’s work to raise rates are plain to see in yield-curve comparisons, as shown in the chart below. More broadly, the Bloomberg U.S. Aggregate Float Adjusted Bond Index fell by as much as 12.7% year-to-date through June 14, 2022—the most it’s lost in this short a time in 40 years.¹

Then there’s SEC yield …

The SEC yield on VGSH was 2.53% as of the end of May 2022. This yield tells us what the bonds in the portfolio may have produced in annualized return based on the fund’s holdings over the 30 days prior to the as-of date. It includes expenses and any other frictions associated with holding a portfolio composed of many bonds.

Of course, for a perpetual bond fund that’s constantly changing as bonds mature out of the portfolio and new bonds are added, the SEC yield can change from day to day. Still, the SEC yield was in the ballpark of what a 2-year U.S. Treasury note was yielding. Most of the time it's lower because SEC yield reflects fund fees.² Given these dynamics, it’s helpful to look to the SEC yield as a reasonable forward-looking picture of the current income of the fund, based on current market value.

… and distribution yield

Then there’s a bond fund’s distribution yield, which is important because it reflects what the fund’s monthly distributions are.³            

The challenge is that VGSH's distribution yield as of May 31, 2022, was 0.57%—well below both the 2.53% that individual 2-year notes were yielding and the 2.53% SEC yield as of that date. Moreover, while VGSH's distributions were trending higher in the rising-rate environment of 2022, the actual distribution yield had not trended meaningfully higher at that point. Put differently, this is an accurate, yet backward-looking, metric; it's not a strong predictor of future earnings or overall total return.

A few reminders

It’s important to remind ourselves of a few fundamental bond ETF mechanics. Given that most fixed income ETFs typically have some type of maturity constraints, it will take time for current portfolio holdings to “roll” out of an ETF, creating space for new, higher-yielding bonds.

Notably, this same dynamic was in play while the Fed was lowering rates to near zero, and bond funds were still holding onto much-higher-yielding exposures even as benchmark yields were dropping as the Fed cut borrowing costs.

Finally, it’s critical to remember the total return benefits of fixed income. While the upward pressure on rates continues to affect bond prices, net new investments in bond funds will steadily lift yields in the portfolio higher as higher-yielding bonds replace lower-yielding bonds in the fund. This means that, over time, the total return of the bond will increase.