What happens to bond funds when interest rates fall?
Bond prices and interest rates move in opposite directions, so when interest rates fall, the value of fixed income investments rises, and when interest rates go up, bond prices fall in value.
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.
High-quality bond investments remain attractive. With yields on investment-grade-rated1 bonds still near 15-year highs,2 we believe investors should continue to consider intermediate- and longer-term bonds to lock in those high yields.
As for fixed income, we expect a strong bounce-back year to play out over the course of 2024. When bond yields are high, the income earned is often enough to offset most price fluctuations. In fact, for the 10-year Treasury to deliver a negative return in 2024, the yield would have to rise to 5.3 percent.
We expect bond yields to decline in line with falling inflation and slower economic growth, but uncertainty about the Federal Reserve's policy moves will likely be a source of volatility. Nonetheless, we are optimistic that fixed income will deliver positive returns in 2024.
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.
Unless you are set on holding your bonds until maturity despite the upcoming availability of more lucrative options, a looming interest rate hike should be a clear sell signal.
In line with the outlook from other investment providers, the firm is forecasting a 5.7% gain in 2024 for U.S. investment-grade bonds, versus 4.9% last year and 2.3% in 2022. (All figures are nominal.)
In December, many investors welcomed the Federal Open Market Committee's unanimous decision to hold rates between 5.25% and 5.5% and signal some rate cuts in 2024. The Federal Reserve's so-called dot plot in December suggested a median fed funds rate of 4.6% in 2024, followed by 3.6% in 2025 and 2.9% in 2026.
Vanguard's active fixed income team believes emerging markets (EM) bonds could outperform much of the rest of the fixed income market in 2024 because of the likelihood of declining global interest rates, the current yield premium over U.S. investment-grade bonds, and a longer duration profile than U.S. high yield.
What is the investment advice for 2024?
With interest rates having peaked last year, growth stocks such as small caps may be poised for a strong performance in 2024. Small-cap stock funds can earn sizable returns over time, and the best small-cap ETFs can earn double-digit returns annually for years.
For now at least, analysts are anticipating S&P 500 earnings growth will continue to accelerate in the first half of 2024. Analysts project S&P 500 earnings will grow 3.9% year-over-year in the first quarter and another 9% in the second quarter.
- Vanguard Total Bond Market ETF (BND)
- Vanguard Core-Plus Bond ETF (VPLS)
- iShares MBS ETF (MBB)
- Invesco Ultra Short Duration ETF (GSY)
- SPDR Bloomberg 1-3 Month T-Bill ETF (BIL)
- iShares Aaa – A Rated Corporate Bond ETF (QLTA)
- Schwab Short-Term U.S. Treasury ETF (SCHO)
- Schwab Intermediate-Term U.S. Treasury ETF (SCHR)
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. It is important to acknowledge that some of those strong recoveries were helped by bond yields that were higher than they are today.
Yields on high-quality bonds have risen back to around their historically normal levels. Higher yields enable bonds to once again play their traditional role as sources of reliable, low-risk income for investors who buy and hold them to maturity.
The largest active bond fund, the $131.6 billion Pimco Income PIMIX, gained 5.9% in the fourth quarter and 9.3% over the year—its best performance since 2012 and well above the 8.1% return on the average multisector bond fund.
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 disadvantages of bond funds include higher management fees, the uncertainty created with tax bills, and exposure to interest rate changes.
Credit-sensitive sectors, like bank loans and high-yield bonds, even provided equitylike returns, as a relatively healthy and stable economy supported them. In 2023, the average fund in the bank loan and high-yield bond Morningstar Categories gained 12.1% each.
It's worth mentioning that it's impossible to time the market. By the time an interest rate hike is announced, bond prices adjust accordingly. But if there are strong indicators that interest rates are going up, it could be a good time to sell.
Is it better to buy bonds when interest rates are high or low?
Investing in bonds when interest rates have peaked can yield higher returns. However, rising interest rates reward bond investors who reinvest their principal over time. It's hard to time the bond market. If your goal for investing in bonds is to reduce portfolio risk and volatility, it's best not to wait.
| Face Value | Purchase Amount | 30-Year Value (Purchased May 1990) |
|---|---|---|
| $50 Bond | $100 | $207.36 |
| $100 Bond | $200 | $414.72 |
| $500 Bond | $400 | $1,036.80 |
| $1,000 Bond | $800 | $2,073.60 |
- Broadcom Inc. (NASDAQ:AVGO)
- Eli Lilly and Company (NYSE:LLY)
- JPMorgan Chase & Co. (NYSE:JPM)
- Berkshire Hathaway Inc. (NYSE:BRK-B)
- Apple Inc. (NASDAQ:AAPL)
- Visa Inc. (NYSE:V)
- Alphabet Inc. (NASDAQ:GOOG)
The United States 30 Years Government Bond Yield is expected to be 3.892% by the end of June 2024. It would mean a decrease of 43.9 bp, if compared to last quotation (4.331%, last update 3 Mar 2024 0:15 GMT+0).
Inflation is a bond's worst enemy. Inflation erodes the purchasing power of a bond's future cash flows. Typically, bonds are fixed-rate investments. If inflation is increasing (or rising prices), the return on a bond is reduced in real terms, meaning adjusted for inflation.
