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Bonds play a critical role in investment portfolios because they provide stability, income and potential capital appreciation. In light of recent interest rate cuts, many investors have ramped up their investments in bonds, specifically in bond funds.
In fact, taxable-bond funds (funds that generate interest income subject to federal income tax) have seen $351 billion in investments in 2024 so far after collecting about $39 billion in September alone, according to Morningstar. That’s up from 2022, when investors pulled a record $216 billion from taxable-bond funds and $119 billion from municipal bond funds, both of which ended up being the worst growth rates in at least 20 years.
The investments haven’t been in one specific type of bond fund, either; investors are shoveling cash into taxable-bond products of all kinds, including active and passive, mutual funds and exchange-traded funds.
But why are investors considering bond funds in a lower rate environment, and what are the potential benefits and drawbacks? Here’s a look at the pros and cons of bond funds in a lower interest rate environment.
What are bond funds?
A bond fund collects money from multiple investors to buy a basket of bonds. Professional managers will either actively choose and manage the bonds in the fund or follow what’s called a passive bond index. As an investor in a bond fund, you own a share of the fund’s overall assets.
Investors may prefer bond funds for several reasons. For one, it’s easier to invest in a bond fund than it is to buy individual bonds. You can simply purchase shares of a bond fund through your brokerage account and it will give you instant diversification, reducing the risk associated with any one single bond.
By adding bond funds into a primarily stock-based portfolio, investors can lower overall volatility. And despite what happened to the stock market in 2022, bonds generally have a strong track record of delivering for investors when equities lag.
Pros and cons of bond funds in a lower interest rate environment
When interest rates fall, bond prices rise. Older bonds offer higher interest rate payments and become more valuable because they provide better returns than new bonds that are issued in the current rate environment.
Bond funds are typically made up of a range of bonds including Treasurys, corporate bonds, mortgage-backed securities and more. Because of this, investors have more diversification when it comes to building a portfolio. Bonds and bond funds are known to attract attention during lower rate environments — and for good reasons — but they don’t come without some downsides to consider.
Here’s a look at the pros and cons of bond funds in a lower interest rate environment.
Pros
- Rise in bond prices: When rates fall, the prices of bonds held by the bond fund go up. This is because the older bonds in the fund pay higher interest rates compared to newer bonds, so the value of your investment goes up.
- Steady income: You’ll have access to those older bonds within the fund that provide a steady, and higher, stream of income.
- Diversification: Bond funds spread your investments out across a number of bonds. Your portfolio therefore isn’t significantly impacted by any single bond’s price movement.
Cons
- Lower yields on new bonds: You’re receiving more money from higher bond prices and interest at first, but that can potentially be offset over time as those bonds mature and newer, lower-rate bonds are added to the fund.
- Sensitivity to interest rate changes: In a lower interest rate environment, bonds are more sensitive to potential inflation (and higher rates) in the future, so the value of the fund could drop over time.
- Limited growth: Because bond prices are already high when overall interest rates decline, there isn’t usually a ton of potential price growth left.
Should you invest in bond funds?
Whether you should put your hard-earned cash into bond funds depends on your individual investment timeline and risk tolerance. Some bonds and bond funds may see an increase in demand when interest rates fall, but what’s important is that you maintain a diversified portfolio overall. Building a portfolio that preserves capital and also provides income is usually a solid bet for long-term success.
Bond funds may be more suitable for investors who seek diversification, professional management (some bond funds are actively managed) and higher liquidity. Purchasing individual bonds might be a better fit for someone who has a higher risk tolerance, longer time horizon and/or the desire to actively manage their own investments.
Bottom line
Bond funds have been a popular investment vehicle in an era of lower rates, but they come with pros and cons. Whether a bond fund is right for you can depend on a few factors including your risk tolerance, time horizon and individual goals. Overall, bond funds might be a solid bet if you seek diversification, prefer someone to manage the fund or want higher levels of liquidity.
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