NEW YORK (CNN/Money) -
I'm a bit confused about how to interpret the recent rise in Treasury bond rates. If I own a mutual fund that holds bonds, is a rise in Treasury rates bad news for me? And do movements in Treasury bonds affect corporate bonds as well?
-- Christina, Sunnyvale, Calif.
Given that the Fed effectively gave notice last week that it will begin boosting the federal funds rate sometime in the near future, you're not the only one wondering how higher interest rates will affect the value of various types of bond and bond funds.
So let me explain how investors who already own bonds or bond funds fare when rates climb.
Bonds and rates
You can think of the relationship between bond prices and interest rates as a seesaw. As one side goes up, the other goes down. So if you already own bonds -- or bond funds -- when rates start climbing, you're almost certainly going to take a hit. It's just a question of how far the prices of the bonds you own (or your fund owns) drop.
The magnitude of the drop in a bond's price in the face of rising rates depends primarily on two variables.
The first is the bond's maturity. The longer the bond's maturity, the more its value will fall when rates rise.
Let's go back to that seesaw analogy. The longer the term of the bond, the farther out it sits toward the end of the seesaw, which means it's going to experience greater ups and downs than a bond that would be closer to the center of the seesaw. This not only makes sense in terms of physics, but economics as well.
If you own a bond paying, say, 5 percent, and rates go to 6 percent, your bond becomes less valuable because it provides a smaller stream of payments. And the longer the bond relegates you to that smaller payment stream, the more its price has to fall to reflect this disadvantage. (Of course, the opposite is true when rates fall.)
The second variable that determines how much of a hit a bond takes when rates rise (or how much it rises when rates drop) is the coupon rate of the bond -- that is, the fixed rate the issuer is contractually bound to pay.
For mathematical reasons too boring and complicated to go into here, the lower the bond's coupon rate, the more its price goes up or down in response to changes in interest rates, and the higher the bond's coupon rate, the less it's price fluctuates with interest rates.
So put these two factors together -- maturity and coupon rate -- and what can we say about how different types of bonds will fare in a rising rate environment?
Well, bonds with shorter maturities will far better than those with long maturities; bonds with higher coupon rates will do better than those with lower coupon rates; and short-maturity bonds with high coupon rates should do best of all, while long-maturity bonds with low coupon rates will get clobbered more than other bonds.
Throw the Treasury into the mix
Now, let's get back your question about whether Treasury rates affect corporate bond rates. Actually, it's not so much that Treasury rates affect corporate rates, but that all bonds take their cues from investors' inflation expectations.
Which means that if investors see rising inflation, bond rates overall are likely to rise to compensate for higher inflation, while expectations of lower inflation lead to lower rates.
It is possible for Treasury and corporate rates can go in different directions for a short time, such as when investors surge into Treasury bonds seeking safety in times of political and/or economic turbulence. But over the long term they tend to move together. So if you read that Treasury bond rates are rising, corporate bond rates are most likely headed north too.
That said, however, corporate bonds have higher coupon rates than Treasury bonds with the same maturity. That's because there's virtually no risk that the U.S. government will default on its obligations, while there is at least some risk a company might.
Given this difference in what's known as "credit risk," corporate bonds must pay higher rates of interest than Treasuries, and bonds of less financially sound companies must pay higher rates than those of more secure firms.
What this means is that even though Treasury bonds and corporate bonds will both get hurt by rising rates, the damage is greater with Treasury bonds because their coupon rates are lower than corporates' of the same maturity.
The practical implications
So what are the practical implications of my little Bonds 101 primer?
Well, the first is that if you're interested in protecting your bond holdings from the ravages of rising rates, you should stick to bonds (or, in your case, bond funds) that stick to the short- to intermediate-term end of the maturity spectrum. The price of short-term bonds will fall, but you'll do much better than with long-term bonds.
In fact, if interest rates don't really spike up, you could come away with only a very small loss or maybe even no loss at all after you factor in the interest payments from the bonds.
The second implication is that you can also limit the damage from rising rates by diversifying beyond Treasury bonds into corporate bonds because their higher coupon rates offer a bit more protection.
You might even want to consider adding a small portion of high-yield, or junk, bonds to your bond portfolio, since these bonds typically have the highest coupon rates and therefore tend to fare best in times of rising rates. Of course, junk bonds are risky in other ways, so I'd limit them to a small portion of my bond portfolio.
If you're interested in putting together a portfolio of bond funds that includes both Treasuries and corporates and that sticks to the short-to-intermediate maturity range, you can do so by going to our Fund Screener, which allows you to screen for funds based on a variety of criteria, including maturity and type of bond fund (Treasury, corporate, high-yield, etc.).
One final note: once you've identified some funds you feel comfortable with, you can get a much better idea of how they'll respond to rising rates by checking out their "duration," a measure of interest-rate sensitivity that I've explained in a previous column.
One question I can't answer, of course, is just how far interest rates will eventually climb. Even the mighty Alan Greenspan can't foretell that. But now that you know the relationship between interest rates and bonds, you can at least take steps to protect yourself a bit.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Mondays.