Interest rates have changed dramatically since 2022. Investors may find that risk profiles in active taxable bond funds also shift as active managers pursue their objective of outperforming their benchmarks in new rate environments. That makes this historic period of interest rate moves a smart time for investors to check the risk profiles of their bond funds. 

We expect interest rates to remain relatively high compared to those since the 2008 global financial crisis,  even if the Fed continues to cut the federal funds rate as expected.  That marks a major change from the low interest rate environment that investors experienced from 2008 through 2022, when it was likely that fund managers increased their credit risk exposure to “reach for yield.”  Then, between March 2022 and October 2023, investors saw the largest increase in the interest rate on the 10-year Treasury since 1981.  When rates change, funds’ investment objectives remain the same, but fund managers may alter their approaches to duration risk and credit risk to adapt to a new era.  

“Just because an investor holds the same fund, it doesn’t mean risk exposures are static,” said Andrew Patterson, Vanguard’s head of active research. “We recommend investors keep an eye on the impact that changes to interest rates can have on manager’s duration and credit strategies.”  

Credit risk and duration risk tend to diverge 

Based on fund-level monthly returns from 1990 to 2023, we analyzed the risk profile of the average invested dollar in actively managed taxable bond fund strategies (active funds) relative to those of their benchmarks. The results suggest that active funds’ relative credit risk decreases as interest rates rise.  Interestingly, we found that active funds’ relative duration risk was only statistically significant when interest rates were in the highest quintile.  

 

As rates rise, relative credit risk tends to fall but relative duration risk may increase

 

Notes: Outlined bars indicate results that were not statistically significant. Data for the period from January 1, 1990, to December 31, 2023. The chart displays the risk exposures of actively managed taxable bond funds relative to their Morningstar benchmarks across five interest rate quintiles from 1990 to 2023. The sample reflects the 15 largest bond fund strategies that invest primarily in U.S. dollar-denominated taxable fixed income securities, collectively accounting for more than 95% of the assets under management (AUM) in Morningstar’s U.S. Category Group of Taxable Bond over the relevant period. To assess the risk exposures of these funds, we calculated the average net return of these active funds each month, weighting by their AUM at the end of the previous month. These monthly asset-weighted returns were then categorized into interest rate quintiles, based on the monthly average of the interest rate of the 10-year constant maturity Treasury during that month. In each quintile, we regressed the monthly asset-weighted returns, adjusted for the 1-month risk-free rate, against duration risk, credit risk, and prepayment risk factors. Duration, credit, and prepayment factors are defined, respectively, as the Bloomberg U.S. Treasury Aggregate Index total return minus the Bloomberg U.S. Short Treasury 1–3 Month Index total return; the Bloomberg U.S. Corporate High Yield Index excess return (versus duration-matched Treasuries); and the Bloomberg U.S. Mortgage-Backed Securities Index excess return (versus duration-matched Treasuries). Similarly, we assessed the risk exposures of these funds’ benchmarks by regressing the asset-weighted Morningstar Category benchmark returns of each month—where weights are determined by the asset sizes of respective categories of active funds of the same month—adjusted for the 1-month risk-free rate, against duration risk, credit risk, and prepayment risk factors. The differences between these risk factors’ coefficients (i.e., risk exposures) for the active fixed income funds and their benchmarks were calculated for each interest rate quintile. Solid bars in the chart indicate a statistically significant difference (p-value below 10%). This article only discusses results on credit and duration risk exposures, as the active funds did not consistently exhibit statistically significant exposures to prepayment risk.   

Sources: Vanguard calculations, based on data from Morningstar, Inc., Bloomberg, and Federal Reserve Economic Data (FRED). 

Key takeaways

An informed approach to active investing involves understanding the risks taken by active fund managers in different economic and financial environments. Some active bond fund investors may have grown accustomed to the risk profiles of their funds during the prolonged low-rate period from 2008 until the Fed hiking cycle began in 2022. There are likely to be long-term benefits to bond fund investors of higher interest rates. Being aware of changes in duration and credit risk in active bond funds in this new environment can assist investors in maintaining an informed investment plan that instills discipline and increases their likelihood of investment success.   

“Checking up on the risk profile of your funds is a good practice as market environments evolve,” Patterson said. “Investors should be aware of the risks that portfolio managers take in different interest-rate environments and be sure to consider them as part of their regular investment review.”   

Notes: 

All investing is subject to risk, including the possible loss of the money you invest. 

Investments in bonds are subject to interest rate, credit, and inflation risk. 

Bloomberg® and Bloomberg Indexes mentioned herein are service marks of Bloomberg Finance LP and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Vanguard. Bloomberg is not affiliated with Vanguard and Bloomberg does not approve, endorse, review, or recommend the Financial Products included in this document. Bloomberg does not guarantee the timeliness, accurateness or completeness of any data or information related to the Financial Products included in this document. 

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Andrew Patterson