Q&A: Interest rates and bond funds

Question: I’m aware of the inverse relationship between bond prices and interest rates but am finding it somewhat confusing. Most of the discussions I hear about bonds these days warn of not locking in for too long a maturity (i.e. longer than three years). What should I expect (in general) for mutual bond funds in an RRSP that are comprised of provincial/federal bonds and corporate debentures as interest rise in the coming years? Presumably these mutual fund unit prices will drop as well, correct? – R.M.B.

Gordon Pape answers: As a general rule, bond funds tend to be weak in a rising interest rate environment. Of course, the fund managers know what is going on and take steps to mitigate the damage such as by reducing term but losses can occur nonetheless. In extreme circumstances, these losses can hit double digits. For example the AGF Canadian Bond Fund dropped 11.35% in the 12 months to Jan. 31/95.

If you want to stay in bond funds and reduce risk, move to short-term funds which are much less vulnerable to the effect of interest rate increases. Staying with AGF, the one-year loss ever experienced by their Short-Term Income Class was 4.53% over the 12 months to Aug. 31/99.

f course, money market funds are the best hiding place when rates are rising. In fact, you’ll actually benefit because yields on the short-term notes they hold will increase.

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