As a follow up to a blog I wrote a few weeks ago (Do You Really Want to Sell Your Bonds Now?), I thought it would be a good idea to provide a little more data about how bond funds might be expected to perform during periods of rising rates.

The following table was developed by bond fund company PIMCO. It highlights the speed at which returns recover after rates rise, using a hypothetical fund based on an index comprising Treasury, mortgage, asset-backed, and investment-grade bonds with an average yield to maturity of 2.27% and duration of 5.36 years:

From the table, if rates were to jump 2% at the beginning of this year, this fund would have lost 5.78% by the end of the year. However, over two years, the fund would have lost only 0.73% per year on average. If you had been holding it when the rate increase occurred, and had kept it for another seven years, you would actually have made more money from it than you would have made had interest rates stayed flat (2.77% vs. 2.61%).

How it this possible? It’s because the losses from the interest rate increase – 10.72% based on the example fund’s duration – are offset fairly quickly both by higher interest income (due to higher reinvestment yields) as well as from the higher yield to maturity (the lower bond prices now have farther to rise as they approach maturity and therefore increase faster). The combination results in a more rapid recovery than one might intuitively expect.

Let’s look at this in dollar terms, and with a real bond fund. Consider a hypothetical couple who invest $560,000 in the Vanguard TIPS bond fund* on March 31, 2013, to provide retirement withdrawals of $20,000 annually with increases each year for inflation. Their projections use a yield after inflation of negative 0.84%, based on the March 31, 2013, 10-year TIPS yield of negative 0.64% minus an additional 0.2% for expenses. The plan is for the withdrawals to last 25 years.

Three months later, interest rates have increased and they discover (to their chagrin) that the fund has lost 7.34%, reducing the value of their fund shares to $519,000. They decide to redo their projections and discover that the 10-year TIPS yield is now positive 0.48%. They are pleasantly surprised to discover that, even though they now have $41,000 less, they can actually withdraw more money from the fund ($21,500) adjusted for inflation over the next 25 years.

Bond fund managers have the ability to actively manage many factors that can result in increased returns as compared to purchasing bonds yourself individually. Notwithstanding getting lower purchase costs since they can buy in much higher volumes, they can additionally manage (for example) yield curve exposure to optimize the amount of “carry” and “roll down” a portfolio can earn. For example, an investment in a five-year Treasury security currently yields about 1.5%, but its total return over a year’s time will be more than 2.5%; the five-year Treasury will age into a four-year Treasury, which today yields about 0.37% less than the five-year Treasury. It’s these kinds of possibilities that suggest that bond funds might not perform poorly even in a rising rate environment, and certainly not as compared to owning individual bonds.

*The author is using this fund solely as an illustrative example and neither recommends nor disapproves it