It seems logical: when stock market volatility increases, fixed income investments can offer some stability.
At this time, however, with interest rates near historic lows—and without any real possibility of moving lower—attempting to reduce volatility with extra fixed income investments is not necessarily the way to go.
As rates eventually increase, values of existing bond funds will decrease. And the longer the average duration and maturity in a bond fund, the bigger the drop in value as the fund pays interest at a rate below market levels.
For example, if you own a corporate bond fund paying two percent interest and rates increase, it likely would be worth less than what you paid. It doesn’t have as much value if it’s paying interest at a lower rate than what’s available from another bond fund.
On the other hand, say you own a corporate bond fund paying six percent. If rates drop and you then decide to sell it, it would likely be worth more than what you paid. That’s because it’s paying a higher rate than what’s available with a similar, newly-issued fund.
Duration looks at average maturities for individual bonds inside a bond fund as well as their ‘call’ features. Bond issuers use calls when they want to reserve the right to pay off the bond and stop paying interest prior to maturity. For example, a school district may issue bonds for 30 years, but elect to return principal after only 10 or 15 years.
Bond funds with shorter durations typically offer lower interest rates than bond funds with longer durations. In some cases, however, it may be more appropriate to own funds with shorter durations because their value will likely be less affected as interest rates increase.