Why do fixed income funds lose value?
Interest rate changes are the primary culprit when bond exchange-traded funds (ETFs) lose value. As interest rates rise, the prices of existing bonds fall, which impacts the value of the ETFs holding these assets.
What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.
The main ways to lose money on bonds include price decreases due to interest rate increases, default or bankruptcy of the bond issuer, call risk, reinvestment risk, and inflation risk. Each of these factors can potentially lead to a decrease in the value of your bond investment or a loss of your initial investment.
Changes in benchmark rates capture macroeconomic factors that affect all bonds in the market—inflation, economic growth, foreign exchange rates, and monetary and fiscal policy. Changes in spreads typically capture microeconomic factors that affect the particular bond—credit risk, liquidity, and tax effects.
Fixed Income Risks
When rates rise, bond prices fall. Conversely, when rates fall, prices rise. These price changes impact the value of the fixed income investment. Movements in interest rates tend to cause price volatility in the bond market, and the risk is higher for longer duration bonds.
It's important to remember that bond funds buy and sell securities frequently, and rarely hold bonds to maturity. That means you can lose some or all of your initial investment in a bond fund.
Just because fixed income funds usually are less risky options doesn't mean there is no risk involved. As with stocks, your fixed income investment could be affected by external factors such as market conditions, inflation, or interest rates.
Bond prices decline when interest rates rise, when the issuer experiences a negative credit event, or as market liquidity dries up. Inflation can also erode the returns on bonds, as well as taxes or regulatory changes.
“Bonds' third-quarter success was mostly a function of their interest rate sensitivity,” says Morningstar analyst Ryan Jackson. Still, for many bond funds, including those in the intermediate-core category (a building block for many portfolios), 2023 is now on track for a third year of losses.
“Although some volatility may continue, we believe interest rates have peaked,” predicts Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. “We expect lower Treasury yields and positive returns for investors in 2024.”
How are fixed income investments valued?
2.1.
A bond's price is the present value of all future cash flows at the market discount rate. The discount rate is the rate of return required by investors given the risk of investment in the bond. It is also known as the required yield, or required rate of return.
Income: All fixed-income securities (with the exception of zero-coupon bonds) provide some form of regular interest payments to investors. This makes the fixed-income market especially attractive to investors whose main investment goal is providing themselves with a steady income.
The main factors that impact the prices of fixed-income securities include interest rate changes, default or credit risk, and secondary market liquidity risk.
Although it seems that fixed income investments are risk-free and 100% safe, nothing is further from the truth. Fixed income investments run credit risk, market risk, movement penalties, hidden fees, transparency in results, among many others.
In current market circ*mstances, with higher bond yields, fixed income investments have become an attractive asset class again from a risk-return perspective. Apart from the attractive yield, bonds also offer resilience for adverse market developments in risk assets like equities.
Given where we are now (i.e., post-Covid, falling inflation, higher rates, restoration of bonds' diversification benefits), we believe that the case for fixed-income is very strong. Although cash rates are currently attractive, investment-grade credit yields are currently offering outperformance.
Fixed income investments also help to reduce the overall risk of your investment portfolio. Depending on the issuer, they can provide a guaranteed fixed return when held to maturity and are a source of stable cash flow.
The fixed rate rose to 0.4% in November 2022 so any I bond purchased after that date should be held. Likewise, you may want to hold on to I bonds issued between May and October 2023. Those I bonds have a fixed rate of 0.9%, which is the highest fixed rate in 16 years.
Why rising interest rates pushed bond prices down, too. Bond interest rates are usually set upon purchasing a bond. When rates rise, new bonds with higher rates are issued and become more desirable than bonds with lower rates. As a result, the value of the bonds people already own with lower rates will fall.
Generally, fixed-income investments are considered less risky than shares, with income from bonds being paid out before any dividends on shares, and bond payouts taking priority over shareholders in the case of insolvency.
What is the outlook for bond funds in 2023?
In 2023, the average fund in the bank loan and high-yield bond Morningstar Categories gained 12.1% each. On the other hand, investors who accepted more duration risk, or sensitivity to shifting yields, stomached an uneasy ride over the past 12 months.
Top four schemes in the category offered over 7%. ICICI Prudential Corporate Bond Fund, the topper in the category, offered 7.60% in 2023. Aditya Birla Sun Life Corporate Bond Fund offered 7.29%. HDFC Corporate Bond Fund gave 7.20%.
Bond prices have an inverse relationship with interest rates. This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up.
The table on the right shows that bond prices often recover within 8 to 12 months. Unnerved investors that are selling their bond funds risk missing out when bond returns recover.
We expect generally good performance during the second half of the year, although volatility may increase, especially for high-yield bonds. Corporate bond investments generally performed well during the first half of the year.
