Rising rates reduce bond funds

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January’s market turmoil affected even the safest bond funds. Some of those that have held up the best have moved away from their traditional investment grounds or have focused on the shorter maturities.

Only a few U.S.-based funds that focus on higher-quality taxable debt either had a positive return or traded flat through January, including interest payments and price swings, the data shows. compiled by Morningstar Direct. More than 300 others posted total losses ranging from minus 0.1% to minus 3.6% during the same period.

These bond funds, known on Wall Street as “core” and “core-plus” funds, typically hold a combination of relatively safe assets such as high-quality corporate bonds, mortgage-backed securities and treasury bonds. The pandemic bond rally helped propel total returns for some core funds as high as 18% just two years ago.

Now investors have stepped up bets that the Federal Reserve will raise short-term interest rates in 2022 to fight inflation, sending yields to their highest levels since the start of the pandemic while triggering wild swings in the stock market and other riskier Wall Street bets. Even municipal bond funds suffered declines.

This year, investors have withdrawn more than $1.6 billion net from U.S. core, core-plus and mortgage bond funds combined, according to data compiled by Refinitiv Lipper through Jan. 26.

Among the funds that best resisted the turn: Putnam Mortgage Securities Fund Class A from Putnam Investments. The fund invests in a mix of commercial and residential equity-backed mortgages and returned 1.5% to investors last month. That beat a return of minus 1.49% on the Bloomberg U.S. index of mortgage-backed securities over the same period. The fund charges an annual fee of 0.89%, or $89 on a $10,000 investment.

Bond funds known on Wall Street as “core” and “core-plus” funds typically hold a combination of relatively safe assets such as mortgage-backed securities and treasury bills.


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Brett Kozlowski, portfolio manager at Putnam, says his team began reducing the fund’s sensitivity to interest rate volatility, or duration, in 2021, in line with the benchmark. by buying shorter-term assets, thus helping to mitigate the impact of rising rates.

Duration is generally higher for longer-term bonds because the longer it takes for investors to recover their money, the more they are exposed to fluctuations in value. Typically, a one percentage point increase in interest rates causes the price of an asset to fall equal to its duration. For example, a fund with a duration of five years will suffer a decline of 5% with a rise in rates of one percentage point.

Duration is also higher for low-coupon bonds, which provide less cash flow to buffer these fluctuations. Other measures of duration can capture the impact of changes in interest rates on bonds that can be redeemed before their maturity date.

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The duration of the Putnam fund stood at around 3.9 years at the end of 2021, compared to around 5.3 years for the Bloomberg index of US mortgage securities.

One opportunity that has helped the fund’s recent performance has been to design an investment vehicle to help provide residential mortgages and then buy the mortgages in bundled securities, he said. Securitized real estate debt has struggled through much of the pandemic and has recently begun to improve, helping to bolster fund returns.

“Betting that rates were going to go up was very difficult because of the volatility,” Kozlowski said. “It’s sometimes very difficult to make calls around the duration, so we tried to minimize that element.”

US government bond yields influence the cost of borrowing, from mortgages to student loans. WSJ explains how they work and why they are so crucial to the economy. Photo illustration: Tom Grillo/WSJ

Another fund that held its value in early 2021: 1290 Diversified Bond Fund Class I, managed by Equitable Investment Management LLC, which returned 0.71% to investors last month, outperforming the return by minus 2.15% over the same period of the Bloomberg US Aggregate Bond index.

The 1290 Fund’s top holdings as of December 31 were two series of US Treasuries maturing in January and July 2023 which yielded 0.13% and 0.11% respectively.

The 1290 Diversified Bond Fund offers shareholders a core-plus bond strategy, allowing it to change duration and credit quality, said Kenneth Kozlowski, chief investment officer at Equitable Investment Management (and no relation to Brett Kozlowski). The fund has reduced duration to around 2.3 years by the end of 2021 by buying short-dated higher quality corporate bonds and US Treasuries in anticipation of changing market conditions.

“The fund’s performance in January illustrates the benefits of such a flexible strategy,” he said.

David Kotok, chief investment officer of Cumberland Advisors, said rising rates should trigger bigger swings in the coming months, but investors should resist the urge to take big steps, such as buying riskier debts, with the relatively safe part of their portfolios.

“Wear a helmet,” he said. “And don’t chase the yield.”

Write to Sebastian Pellejero at [email protected]

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