How Do Interest Rates Affect Bond Fund Yields?

Buying Bonds

• Bond funds normally make monthly dividend payments, but many of the bonds in the fund only make semi-annual or annual interest payments. Therefore, the bond manager must buy bonds with different issue dates so that the fund receives income on at least some of the bonds on a monthly basis. When bonds reach maturity, the fund manager receives a return of premium from the bond issuer and must use that cash to buy new bonds for the fund.
  
  

Market Prices

• If you retain ownership of a bond until it reaches maturity, you receive a return of premium. If you decide to sell a bond before maturity to another investor, that investor may pay you the par value of the bond. However, if higher yielding bonds are available, that investor may only agree to buy your bond if you sell it at a discount. Likewise, if the yields on newer bonds are lower than your bond, you can sell your bond for a premium. Consequently, bond fund managers must shop around for the best deals when buying new bonds for the fund. If interest rates are falling, new bonds have lower yields than the older bonds in the fund and this causes the dividend payments to decrease.
  
  

Short-Term

• Short-term bond funds normally contain bonds with a duration of no more than a few years. As with all bonds, price fluctuations caused by interest rate movements impact short-term bonds. However, rate movements in a short-term fund are less significant than in a long-term fund. If you cannot find a buyer willing to pay par value for a six-month bond, it makes sense to retain ownership of it for a few months and then get a return of premium. Additionally, the interest rates available on bonds issued this month are unlikely to differ greatly from yields on bonds sold a few months ago -- unless of course a major event such as a stock market crash occurred in the interim. People selling long-term bonds must often take the best deal they can get rather than wait until maturity.
  
  

Inflation

• Aside from dividend fluctuations, interest rates can also impact the yield on a bond fund, even if the actual amount of the dividend payment never changes. If interest rates on bonds and other securities remain very low for a long time, then inflation may exceed the returns on your investment. When this happens you continue to receive the same yield on your investment, but since everything costs more, you cannot buy as much with your money. Therefore, bond funds and other interest rate sensitive instruments expose you to inflation risk.