One of the favourite arguments of active managers and financial advisors selling actively managed mutual funds is that active management will protect you in a down market. Let’s think about this in the context of bond funds. When interest rates go up, bonds will generally fall in price. With interest rates as low as they are now, wouldn’t you be a fool to buy a bond index fund as opposed to an actively managed bond fund?

In fact, you would not be a fool. The performance of actively managed bond funds has been just as dismal as that of actively managed stock funds compared to their benchmark indexes. Over the 15 years ending in 2016, less than ⅓ of U.S. bond funds were able to beat their benchmark index.

If active management isn’t the answer, and interest rates really do have nowhere to go but up, should you still expect positive returns from your bonds?

In this entry of Common Sense Investing, I’m going to tell you why you don’t need to be afraid of bond index funds.

When it comes to bond performance and interest rates, the factors that matter most are the magnitude of any interest rate increase, and the average duration of your bond portfolio. Duration is a measure of price sensitivity for bonds, where higher duration indicates greater price sensitivity to changes in interest rates. If interest rates were to increase by 1%, a bond fund with an average duration of 5 years would be expected to drop by 5%. Bonds with longer duration are increasingly sensitive to interest rates, but they also have higher expected returns.

Increases in interest rates will likely result in negative short-term performance for bonds. These negative effects become more pronounced as the duration of the bond portfolio increases. This is a fairly standard risk/return trade off.

With interest rates as low as they are now, a common thought process for investors is that future bond returns must be low or negative going forward, because interest rates are either going to stay low, resulting in low yields, or rise, causing bond prices to fall.

This thinking ignores an important aspect of the situation. As interest rates go up, new bonds are issued at the now higher rates. Think about a a bond index fund. It is a fund that owns a bunch of bonds, based on an index. A bond index includes bonds based on a set of criteria. For example, the Barclays Capital US Aggregate Bond Index only includes bonds that have at least one year remaining until maturity.

The index usually re-balances monthly, meaning that bonds in a bond index fund that no longer meet the criteria of the index are sold, and new bonds are purchased. While it is true that bonds in the fund are likely being sold at a loss during a period of rising interest rates, the new bonds being purchased will have higher yields such that the index fund will eventually recover from any losses.

Bond index fund prices may decline with rising interest rates, but over time it is expected that as the index rebalances into new bonds with higher coupons there will be positive long-term performance. Long-term expected bond returns are independent of future interest rate scenarios, but realizing any expected return will almost always come with periods of volatility.

If you are thinking about ditching bonds altogether, remember that they are there to help you in bad markets.

A really bad year for bonds is not nearly as bad as a really bad year for stocks. The worst 12 months in recent history for the FTSE TMX Canada Universe bond index, an index representing Canadian bonds, was between July 1982 and June 1983 when it posted a negative 7.90% return. Over that same period, the S&P/TSX composite index, an index representing Canadian stocks, dropped by almost 40%.

Similarly, Canadian stocks dropped by 33% in 2008, while Canadian bonds posted a positive 6.4% return.

If you are concerned about low or negative returns in the bond portion of your portfolio due to low interest rates, an active manager is not the solution. It is expected that bond index funds will outperform actively managed bond funds over the long-term. One option might be to reduce the duration of your bonds, decreasing their sensitivity to interest rates, but doing so will also decrease your expected returns.

Even if interest rates are expected to rise, bond index funds continue to have positive long-term expected returns. You might see a short-term decline in bond prices, but that does not mean that the bonds are no longer doing their job. Investing is a long-term game. If nothing else, bonds act as your buffer against down markets, so unless you have a stomach of steel, it’s probably worth keeping them around.

Join me in my next post where I will tell you why you should not be using your TFSA as a day trading account.

I’ll be talking about a lot more common sense investing topics in this series. I want these videos to help you to make smarter investment decisions, so feel free to send me any topics that you would like me to cover.