Why do bond mutual funds fall when interest rates rise? 5 checks before panicking that you've 'lost money on safe assets'

You think, ‘Government bond yields have risen. Bonds are a good deal now,’ but when you check your account, the bond mutual funds you hold are down. This seems like a contradiction, but it is a normal occurrence with bonds.

On September 24, the 10-year Japanese government bond yield rose to a 30-year high in the Japanese market after the long weekend. This was because selling spread to Japanese government bonds following the sharp drop in U.S. Treasuries. Distributed by Reuters

The goal of this article is not to decide whether you should sell your bond mutual funds immediately. It is to help you categorize whether your product is ‘in the process of benefiting from new, higher interest rates’ or ‘carrying price fluctuations that do not match your time horizon for using the money,’ through five checks.

Why existing bonds fall when interest rates rise

Suppose a bond paying 1% interest per year was trading at 1 million yen until yesterday. If a new bond with the same creditworthiness and maturity paying 2% per year is issued today, most people will choose the 2% bond. To sell the 1% bond, the price must be lowered to increase the yield for the buyer.

This is the basic principle of ‘rising interest rates = falling existing bond prices.’ For new buyers, it means higher yields; for those holding from the low-interest era, it means a temporary price drop. The same news has opposite meanings.

If you hold individual bonds until maturity, you can expect redemption at face value if the issuer pays as promised. However, bond mutual funds rotate many bonds and, in principle, do not have a fixed maturity for individual investors. The net asset value fluctuates daily.

Check 1: Individual bonds or bond mutual funds?

Individual bonds have a maturity date. If you hold a 1-million-yen face value bond until maturity without selling it midway, you can wait for redemption even while watching the price drop in the interim. Of course, credit risk, currency, taxes, and issuance conditions remain.

Bond mutual funds continuously hold and rotate bonds. Holding a ’10-year government bond fund’ for 10 years does not guarantee that your principal will be returned. The ’10 years’ in the name often refers to the duration characteristics of the bonds held, not the maturity for the purchaser.

ETFs are also traded at market prices, and even if there are distributions, the principal price changes. Even if the product name contains ‘government bond’ or ‘bond,’ it is not the same as a deposit.

Check 2: Is the duration long?

A representative measure of how easily a price moves in response to interest rate changes is duration. Simply put, if the duration is 7, it serves as a guide that when interest rates rise by 1 point, the price will move in a direction that drops by about 7%. Actual changes vary depending on convexity, held bonds, and credit spreads.

Funds centered on short-term bonds are relatively less affected by interest rate changes, while those centered on long-term bonds are more likely to be affected. If you buy ultra-long-term bonds looking only at high yields, you may end up with large unrealized losses due to subsequent interest rate hikes.

Look for ‘duration’ or ‘average remaining maturity’ in the prospectus or monthly report. If you cannot find them, check with the asset management company’s explanations or your financial institution.

Check 3: When do you need the money?

If you put 1 million yen for a car purchase next year into a long-term bond mutual fund and it drops 8% in a year, you will have 920,000 yen. Even with 20,000 yen in distributions, you will be short. For near-term expenses, yen deposits with small price fluctuations are more suitable.

If you do not plan to use the money for over 10 years and your goal is to soften the price movements of stocks, there is room to hold bond mutual funds. However, do not ignore your usage timeline just because of the word ‘safe’.

Before buying a bond mutual fund, write down the minimum number of years until you need the money. If it is within 3 years, strictly evaluate whether you can wait for price fluctuations and recovery.

Check 4: Domestic bonds or foreign bonds?

Foreign bond funds fluctuate based on exchange rates in addition to bond prices. Even if dollar-denominated bonds rise, if the yen strengthens, the yen-converted net asset value may fall. Funds with currency hedging incur hedging costs, which can erode yields when the interest rate gap between Japan and the U.S. is large.

Are these funds intended for use in yen, or are you preparing for dollar-denominated expenses? Decide the currency purpose first. ‘U.S. Treasury yields are high’ alone does not determine the take-home amount for someone living in yen.

Check 5: Are you mistaking distributions for profit?

In monthly distribution funds and similar products, distributions may come from a partial refund of principal, not just fund profits. If the net asset value falls after a distribution, receiving cash does not necessarily mean your total assets have increased.

If you purchased for 1 million yen, received 30,000 yen in distributions, and the net asset value equivalent is 940,000 yen, the total is 970,000 yen. If you only look at the 30,000 yen as ‘profit,’ you will overlook the loss. Check the total of post-tax distributions and net asset value.

Rising interest rates are not all bad

Bond mutual funds replace low-yield bonds that reach maturity with new high-yield bonds. While prices may fall in the short term, improved interest income may support recovery in the long term. The speed of this replacement depends on the fund’s duration characteristics.

Therefore, it is extreme to sell just because of a one-day drop, or to buy just because interest rates are rising. Check your holding purpose, time horizon, and duration.

Three cases for 1 million yen

Person A needs 1 million yen for tuition in one year. Long-term bond funds are a mismatch for this goal. Allocate to yen assets with smaller price fluctuations.

Person B is saving for retirement in 15 years, with 700,000 yen in stocks and 300,000 yen in cash. If adding bonds to soften stock volatility, judge based on the ratio of stocks, bonds, and cash as a whole.

Person C plans to withdraw 50,000 yen per month after retirement. First, create a mechanism to keep several years’ worth of expenses in cash or short-term assets so that long-term bonds do not have to be sold at a low price.

All three people heard the same news about ‘rising government bond yields,’ but their actions are different.

What to do today

Open the monthly report for your holdings and write down: 1) individual bonds or mutual funds, 2) duration, 3) shortest time until use, 4) currency/hedging, and 5) profit/loss including distributions.

If you can explain these five points and they match your usage timeline, there is little need to panic and sell based on a single day’s drop. If you cannot explain them, or if you plan to use the money within three years, there is room to reduce the amount, move to short-term assets, or consult with your financial institution.

What is important in an era of rising interest rates is not the old saying that ‘bonds are safe.’ It is which bonds you hold, for how many years, and in what currency. In the paid article, I will provide a practical table for choosing individual bonds, bond mutual funds, deposits, and foreign bonds across seven levels.

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Distinguishing between ‘unrealized losses’ and ‘failure’

When the valuation drops, we reflexively think, ‘I made a bad purchase.’ However, with bonds, the fact that there is an unrealized loss and the failure of having bought a product that does not fit your purpose are not the same thing.

For example, consider someone who holds a domestic bond fund to soften the price movements of stocks with funds they will not use for over 10 years. Even if it drops 5% temporarily due to rising interest rates, if bonds provide relative support during a phase where stocks drop significantly and can be used for periodic rebalancing, their role remains. Conversely, if you bought a long-term bond fund to secure tuition fees for two years from now and must sell on the day you need the money, even a slight unrealized loss is a design problem.

The order in which you should look is not ‘how much it dropped,’ but 1) when the funds will be used, 2) whether mid-term liquidation is necessary, 3) what degree of price decline was anticipated, and 4) whether the product is fulfilling its expected role. If you look only at the price, anxiety will grow. If you look from the perspective of your purpose, you can break it down into choices: sell, hold, or change how you buy in the future.

Three things easily overlooked in yield displays

The first is what the displayed yield actually means. The final yield of an individual bond, the distribution yield of a mutual fund, and the return rate over the past year are different things. In principle, the final yield is an annual rate based on the premise that you hold until maturity and that interest payments and redemption are carried out as scheduled. The distribution yield may look high due to special distributions that are essentially a partial refund of principal. The past return rate is not the amount you will receive in the future.

The second is fees. In bond funds, trust fees are deducted daily, and for foreign currency-denominated products, there are exchange fees at the time of trading. Even if a yield of 4% is displayed, if the costs are 0.8% per year, the difference is not small. Furthermore, there is also the exchange loss when converting back to yen.

The third is credit. Even if government bonds and corporate bonds are both ‘bonds,’ the entity repaying them is different. A high yield is not a gift; it is compensation for anxiety about repayment ability, difficulty in trading, and the length of the period. It is important not to conclude in one line that ‘it is safe and profitable because the yield is higher than a deposit.’

Three steps to take before selling

First, check the ‘effective duration,’ ‘average remaining period,’ ‘currency,’ ‘presence of currency hedging,’ and ‘trust fees’ on the product page. If you cannot find them, open the investment report or monthly report. Even if the product name contains ‘stable’ or ‘income,’ it does not mean the principal is guaranteed.

Next, return your reason for purchase to a single sentence. It is one of: ‘I will use it in 3 years,’ ‘to soften stock declines,’ or ‘I plan to use it in foreign currency.’ If that reason is still valid, the need to sell based solely on daily prices is thin. If you cannot write down a reason, or if you were investing emergency funds, fix where you keep your money before worrying about market predictions.

Finally, think of a way to avoid making a black-and-white decision all at once. These are small adjustments, such as gradually moving from long-term bonds to short-term bonds, changing only new investments to a different product, or returning only the amount equivalent to living expenses to cash. You do not need to accurately guess the peak of interest rates. Reducing maturity mismatches is more reproducible than guessing.

What the rise in Japanese government bond interest rates indicates

What is important in this news is not just the one day that ‘government bonds were sold.’ It is that even in Japan, where low interest rates have continued for a long time, we have entered a phase where the conditions for cash, deposits, government bonds, and home loans are being reviewed simultaneously. The possibility of rising deposit interest rates is a tailwind for households, but it is a headwind for the prices of low-interest bonds already issued. While future interest will increase for those buying new bonds, the valuation of those who bought previously can fall.

In other words, rising interest rates do not affect everyone the same way. The answer changes depending on whether you are a borrower or a lender, whether you already hold them or are buying now, and whether it is short-term or long-term. Headlines like ‘Interest rate rise = profit’ or ‘Interest rate rise = loss’ do not reach your own judgment.

Today’s step is to write the ‘year of use’ and ‘duration’ next to the names of the bond products you hold. If these two are significantly misaligned, it is a sign to review your allocation before pressing the buy/sell button. Do not guess interest rates; organize them into a form that will not cause trouble on the day you need them. That is the way to truly use safe assets safely.

Finally, summarize your judgment on one sheet. 1) Avoid price fluctuations if the money is to be used within a year, 2) check the maturity and issuer for individual bonds, 3) look at the duration and costs for funds, 4) estimate a 10% yen appreciation for foreign bonds, 5) check if the purchase purpose has been broken before selling. This is the order.

When the valuation is in the red, we tend to think only about recovering the loss. However, what households need is not to return to the past purchase price, but to protect future expenditures. Do not use the purchase price as a standard; ask yourself if you would buy that product today for the same amount. If you can explain the reason for buying and the deadline and limit match, you can consider holding it. If you cannot explain it, do not move everything at once; return the necessary funds to a safe place.

Save this article, and the next time you see a headline about rising interest rates, start with these three questions: ‘Am I a borrower or a lender?’, ‘Do I already have it, or am I buying now?’, and ‘When will I use it?’. You should be able to see why the answer changes even for the same news.

• Does the product have your own maturity date?

• Have you grasped the price impact of a 1% rise in interest rates?

• Can you wait until you need the funds?

• Can you withstand a 10% appreciation of the yen?

• Have you added up the distributions and the principal?