With interest rates at record lows, the real interest rate risk is that rates will rise, causing the value of all sorts of bonds and bond funds to fall. Interest rates and bond prices move in opposite directions. All else being equal, when interest rates rise, the value of a bond falls in value. Conversely, when interest rates fall the value of a bond rises. Interest rates have been falling for over 20 years, which is the reason why the performance of bond funds has been so spectacular during that time.
Just as the performance of bond funds has been spectacular over the last 20 years as rates have fallen, their performance would be equally as bad if rates reverse course and start to rise. However, not all bond funds have the same size reactions when interest rates rise and fall.
Why you shouldn't ignore interest rate risk.
Lack of awareness of interest rate risk causes many investors to severely underestimate their total portfolio risk. For example, a retiree on a fixed budget may invest in a government bond fund because U.S. government bonds are generally considered to be some of the safest bonds in the world. However, the word "safe" here refers to their credit risk.
While long-term government bond funds have basically zero credit risk, they have a lot of interest rate risk. In fact, if interest rates rise by just 1 percent, the value of many long-term government bond funds will drop by 10 percent or more. Hardly the safest bond funds in the world when looked at from that standpoint.
How do you know how much interest rate risk a fund is taking?
The concept of interest rate risk is a little hard to understand at first, but luckily knowing how much interest rate risk a fund is taking is easy. For this we look to a number called duration. If a fund has a duration of five, a 1 percent increase in interest rates will be matched by a five percent drop in the value of the fund, all else being equal. If the fund has a duration of two then, all else being equal, a 1 percent rise in interest rates will result in the value of the fund falling by approximately 2 percent.
Where can you find a fund's duration?
We list the duration on all funds we rate at Learnbonds.com in the risk versus returns section of our rating reports. If you don't find the fund you are looking for there, you can go directly to the mutual fund company (such as Vanguard) or ETF sponsor's website (such as iShares) to look up the duration.
The Bottom Line
When choosing the bond fund that is right for you, you want to find the best mix of total return and how much credit and interest rate risk the fund is taking to generate that return. A fund that takes a lot of interest rate risk and/or credit risk is not necessarily a bad fund, so long as you are aware of this, and feel that the fund's return will adequately compensate you for that extra risk.
In the current environment, any fund with a duration of more than five has too much interest rate risk. With rates so low, you are not getting enough extra compensation for extending your duration past five years.
If you're looking for a broad bond mutual fund that does the best job of providing great returns with both low credit and interest rate risk, check out the DoubleLine Total Return Fund.
David Waring is co-founder of bond education website Learn Bonds. If you've watched a YouTube video on technical analysis or forex trading, you have probably seen one of the over 100 videos that he produced. His trading education videos have been streamed over 6 million times and counting.