Why rising interest rates threaten bond funds

Bond funds, including mutual funds and exchange-traded funds (ETFs), are popular because they have appealing features. But they do have some significant disadvantages.

Bond funds are liquid and are less volatile than equity funds, and they typically pay monthly income. They come in many flavors, from the lowest-risk offerings like short-term US Treasury funds to riskier investments such as junk-bond funds that offer higher rates and potentially higher returns. Municipal bond funds pay interest that’s free of federal income tax and sometimes state tax.

But there is one big downside. When interest rates rise, the share prices of bond funds decline because lower-paying bonds will be worth less. In 2021, Morningstar’s core bond index dropped 1.61% while its US government bond index fell 2.28%.

One way to reduce volatility is to invest in bond funds with shorter maturities. They hold their value better than longer-term funds when rates rise, but short-term funds pay very modest yields today.

While bond funds aren’t as volatile as stock funds, nevertheless, even modest declines can be disconcerting to investors who look to them for stability. And it’s likely interest rates will continue to rise in 2022. The chairman of the Federal Reserve has promised to hike rates more than once this year to combat inflation.

What are the alternatives for investors and savers who want to shelter their money from risk, get a competitive interest rate and ensure their principal is guaranteed?

Safe Alternatives: Bank CDs and Fixed Annuities

One choice is a certificate of deposit. Offered by banks and credit unions, CDs offer rock-solid safety because they are insured by the federal government up to $250,000 per bank, per person. If you have more money to invest than that, you can get full protection by spreading out your CD money among multiple banks. Terms from a few months to 10 years are available.

But there’s a big price for safety: current rates are very low. As of March 1, 2022, for example, the top rate for a three-year CD was just 1.30%, according to Nerdwallet.

Deferred fixed annuities offer another route. They’re called fixed because they guarantee your principal. They are distinct from income annuities, which guarantee current or future income payments.

When you’re saving for retirement, you can build your savings faster because fixed annuities are tax-deferred and can pay more interest than CDs and most bond funds. Once you’re retired, they can produce safe, dependable income.

Tax deferral gives annuities a distinct advantage over CDs and bond funds (other than muni bond funds). Interest isn’t taxed until you withdraw it from your annuity, and you can postpone taxation indefinitely by rolling over the proceeds to another annuity, via a tax-free 1035 exchange, when the annuity surrender term ends.

Deferred annuities are not for everyone. If you withdraw money from an annuity before age 59½ you’ll pay a 10% IRS penalty on the interest you receive in addition to federal and state income taxes on it. (The IRS will waive the penalty if you’re permanently disabled.) So, only people who are already 59½ or are sure they won’t need the money before that age should buy an annuity. Also, you may be penalized by the insurer if you make excessive withdrawals before the surrender term ends.

Additionally, annuities are not insured by the FDIC. They are, however, guaranteed by the issuing insurance company. As a backup, state guaranty associations are required by state law to cover fixed annuity owners should the insurer fail. Coverage limits vary by state.

Fixed-Rate and Fixed-Indexed Annuities

There are two popular types of fixed deferred annuities: fixed-rate annuities and fixed-indexed annuities.

Fixed-rate annuities that offer a multi-year rate guarantee behave much like a CD, paying a set, guaranteed rate of interest for a specified period. When you buy one, you shift the risk of rising interest rates to the insurance company. Terms of two to ten years are available.

Rates have increased a bit in 2022 so far. As of early March, you could get up to 2.80% for a three-year term and up to 3.27% for a five-year annuity, for example.

Fixed-index annuities offer another approach for people who don’t mind getting an interest rate that fluctuates each year. When the stock market goes up for the year, you’ll get a share of the gain as an interest-rate credit. Because of various caps and participation rates, you may get only part of the market’s annual gain as measured by an index such as the Dow Jones Industrial Average or S&P 500.

If the market index is negative for the year, you’ll typically get no interest but won’t lose anything. Because of that fluctuation, these products aren’t usually appropriate for people who need current income to cover living expenses. Instead, they work best as long-term instruments that let you build wealth for retirement through tax deferral while eliminating the risk of losing money or sleep when the stock market tanks, as it does periodically.

The disadvantage is that if the stock market goes on a tear for several years, you’ll get only a portion of the gains. But for many investors who are risk-averse but still want to get growth, that’s a trade-off they’re willing to make. The key is to understand the limits on the upside and downside protections so you can choose one that you’re most comfortable with.

Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities. He’s a nationally recognized annuity expert and author. A free rate comparison service with interest rates from dozens of insurers is available at https://www.annuityadvantage.com or by calling (800) 239-0356.