E What Types Of Bonds Are Attractive In A Rising Rate Environment?

Bonds are an important part of portfolios, even if in small amounts. They serve to moderate volatility and minimize maximum drawdowns. Over the past 35 years, bonds have generated interest income and capital appreciation as interest rates declined from very high to very low levels. We are now in a period of rising interest rates, in which bonds with fixed payments will generate interest income and capital depreciation.

The short answer now, in terms of publicly traded funds, is floating rate bank loans, below investment grade corporate bonds, preferred stocks and limited-term municipal bonds – noting that there are significant risks with floating rate bank loans and below investment grade bonds if the economy deteriorates.

We come to this conclusion by preferring those bond fund types that have both a current real, after-tax yield; and that would be expected to have a positive total return in a period where their yield rises by 1% to keep abreast of the market.They are shown in “Performance Group A” in this table.

(Click on image to enlarge)

Performance Group B has a positive total return in a period with a 1% yield increase, but does not have a real, after-tax yield.Performance Group C has a real, after-tax yield, but is expected to have a negative total return in a period with a 1% yield increase.Performance Group D has a negative outcome under both conditions.

We should also note that TOTL in Group D is an actively managed multi-asset fund that may be able to avoid the indicated outcome by modifying its composition.However, as of the last report it is in Group D.

If interest rates were to remain essentially where they are now, then there are attractive types in Group C.

3-Yr Weekly Total Return Charts for Group A Funds 

3-Mo Daily and 1-Yr Weekly Total Return Comparison Charts for Group A Funds vs Aggregate Bonds 

3-Year Weekly Total Return Charts for Group C Funds 

Real, after-tax yield is a simple concept that we all understand: (yield) – (inflation) – (tax rate times yield).

Total return when interest rates change is a less obvious function of duration

Duration estimates bond price change when the bond yield changes in response to change in market rates.The seesaw image next to the axiom illustrates the concept:yield up / price down; or yield down / price up. 

Duration is a linear estimating tool for price change due to interest rate changes and is more accurate for small interest rates changes than for large interest rate changes. The actual relationship between bond price and changes in interest rates is curved and is called “Convexity”.  We are assuming in this letter that duration is sufficient for reasonable estimates of bond price changes as interest rates change over the next 12 months. Those rate changes will be heavily influenced by the Federal Reserve raising its overnight rate, dropping out as a buyer of bonds in the open market, and non-reinvestment of its maturing bonds; as well as increased Treasury issuance because of the larger government deficit. 

Credit Spread Risk:

With Treasury bonds, by definition there is no credit risk. The US government is assumed to always pay interest and redeem maturing bonds. They may do so with depreciated Dollars, but it is assumed that the nominal amounts will always be paid. Every other type of loan or bond has some level of credit risk – risk of not paying interest or defaulting on amortization payments or redemptions at maturity. They can be called “credit bonds”. Credit bonds have higher yields than Treasuries for any given maturity to compensate for risk.

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Disclaimer: "QVM Invest”, “QVM Research” are service marks of QVM Group LLC. QVM Group LLC is a registered investment advisor.

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Valdis Freibergs 1 year ago Member's comment

Profit of bonds is a future of citizens of America!Income of other funds is the question.

Anastasija Janevska 1 year ago Member's comment

Can you elaborate what you mean?