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.
Historical 10-year Treasury bond yields 1962–2022
Note: Data include effects on bond yields related to the Federal Reserve’s July 27, 2022, meeting.
Source: Board of Governors of the Federal Reserve System (U.S.), Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis, retrieved from FRED, Federal Reserve Bank of St. Louis—January 31, 1962, through July 31, 2022.
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 2.25% to 2.50%—up from a range of 0.00% to 0.25% before the Fed started increasing rates. The Fed’s most recent rate hike, on July 27, was 75 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
Treasury yield curve change from year-end 2021 to end of July 2022
Data include effects on bond yields related to the Fed’s July 27, 2022, meeting.
Source: Board of Governors of the Federal Reserve System (U.S.), Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis, retrieved from FRED, Federal Reserve Bank of St. Louis—as of December 31, 2021, and July 31, 2022.
Back to bond basics
With the rapid increase in rates, different metrics can appear to paint different pictures for expected fixed income returns. Therefore, it’s crucial to have a thorough understanding of different yield metrics and what they mean.
Let’s explore common fixed income yield measures used in bond funds and how they can be better understood in the context of a new environment of possibly sustained inflationary pressure.
You might hear such terms as “SEC yield” or “distribution yield” but not be able to map those useful bond fund metrics to data points you hear in the news―data points that focus on changes in the federal funds rate, 10-year U.S. Treasury yields, or 30-year mortgage rates.
Aggregate bonds are represented by the Bloomberg U.S. Aggregate Bond Index.
Source: Bloomberg, from January 31, 2000, through July 31, 2022.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Key bond fund metrics
How do changes to the federal funds rate, which the Fed controls, affect the bond funds you own?
As an example, let’s look at a snapshot from earlier this year that shows how rising rates affected different yield metrics of Vanguard Short-Term Treasury ETF (VGSH), a portfolio composed of U.S. government debt with effective maturity of 2 years. From October 31, 2021, through May 31, 2022, yields on individual 2-year notes rose by about 200 basis points, to 2.53%.
|Yield measure||October 2021||May 2022||Impact of rising rates on yield metrics|
|2-year Treasury yield||0.48%||2.53%||This widely followed measurement of short-term rates reflects real-time market expectations. Because it distills the market consensus, it doesn’t necessarily move in lockstep with the federal funds rate.|
|VGSH YTM||0.49%||2.48%||The yield to maturity (YTM) for VGSH closely tracks the 2-year Treasury yield given the proximity of the fund’s overall composition to the 2-year key rate. (The average effective maturity and the average duration of VGSH were 1.9 years and 2.0 years as of May 31, 2022, respectively.)|
|VGSH SEC yield||0.34%||2.53%||Changes in the SEC yield for VGSH typically follow the YTM because of the nature of the calculation. SEC yield requires averaging the yield to maturity of the fund’s holdings over the prior 30 days and accounts for fund expenses. In some cases, as in May, it can overshoot the YTM because of yield volatility in the prior 30 days.|
|VGSH distribution yield||0.28%||0.57%||The yield measure that lags most, the ETF’s distribution yield, hasn’t yet caught up with the rise in rates. In a falling rate environment, the opposite occurs, and the distribution yield may be higher than other yield measures.|
2-year Treasury yield
Impact of rising rates on yield metrics
This widely followed measurement of short-term rates reflects real-time market expectations. Because it distills the market consensus, it doesn’t necessarily move in lockstep with the federal funds rate.
Impact of rising rates on yield metrics
The yield to maturity (YTM) for VGSH closely tracks the 2-year Treasury yield given the proximity of the fund’s overall composition to the 2-year key rate. (The average effective maturity and the average duration of VGSH were 1.9 years and 2.0
VGSH SEC yield
Impact of rising rates on yield metrics
Changes in the SEC yield for VGSH typically follow the YTM because of the nature of the calculation. SEC yield requires averaging the yield to maturity of the fund’s holdings over the prior 30 days and accounts for fund expenses. In some cases, as in May, it can overshoot the YTM because of yield volatility in the prior 30 days.
VGSH distribution yield
Impact of rising rates on yield metrics
The yield measure that lags most, the ETF’s distribution yield, hasn’t yet caught up with the rise in rates. In a falling rate environment, the opposite occurs, and the distribution yield may be higher than other yield measures.
Note: Because of data availability time frames, figures in this table don’t reflect the Fed’s 75-basis-point rate hikes on June 15 and July 27, 2022.
Sources: 2-year U.S. Treasury yields from the Board of Governors of the Federal Reserve System (U.S.), retrieved from FRED, Federal Reserve Bank of St. Louis—as of October 31, 2021, and May 31, 2022. Data on VGSH yield to maturity, VGSH SEC yield, and VGSH distribution yield are from Vanguard—as of October 31, 2021, and May 31, 2022.
VGSH standardized performance
Average annual total returns, periods ended July 31, 2022
|VGSH (market price)||VGSH (NAV)||Benchmark*|
VGSH’s expense ratio was 0.04% as of July 31, 2022. The ETF was launched on November 19, 2009.
Source: Vanguard, as of July 31, 2022.
*Spliced Bloomberg U.S. Treasury 1–3 Year Index in U.S. dollars (Bloomberg U.S. 1–3 Year Government Float Adjusted Index through December 11, 2017; Bloomberg U.S. Treasury 1–3 Year Bond Index thereafter).
The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so investors' shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit vanguard.com/performance.
Then there’s SEC yield …
The SEC yield on VGSH was 2.53% as of the end of May. 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 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 are trending higher in the rising-rate environment, the actual distribution yield hasn’t exactly trended higher this year. 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.
As the chart above shows, most of the returns from bonds and bond funds come from the income portion of a fixed income security’s return profile and not from the price portion.
It’s not that changes to a bond’s price don’t matter. They matter a lot more than yields do in the short term. But price changes matter less to investment outcomes over the longer haul.
In other words, a portfolio duration longer than the investment timeline means prices matter more, and a duration shorter than the timeline means yields matter more. In the end, adapting to rising rates comes down to matching the duration of a bond portfolio with your investment timeline.
What are bond funds?
1Vanguard, using data from December 31, 2021, through July 31, 2022.
2SEC yield is an annualized percentage of the income over net asset value (NAV) accrued by the fund in the last 30 days, minus fund expenses.
3The distribution yield is an annualized percentage of the previous month’s income paid to investors, divided by the average fund NAV over that period.
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Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.