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The Bond Investor’s Dilemma: 3 Funds to Avoid in a Rising Rate Environment

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The U.S. interest rate environment is highly uncertain and though we might see lower interest rates in late 2024, there’s no way to be sure..

Although I hold a specific view of interest rates, many might disagree. I’m aware of investors who think interest rates will stay higher for longer. As such, I decided to author an article that aligns with market participants’ outlook instead of mine.

I screened for three bond funds that might struggle in a higher-for-longer interest rate environment. Methodologically, I emphasized key risk premiums and asset-liability relationships. Moreover, I overlayed return-based dynamics such as dividend structures.

Without further ado, here are three bond funds that might capitulate in an elevated interest rate environment.

Dynex Capital (DX)

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Dynex Capital (NYSE:DX) is a mortgage real estate investment trust (MREIT) that emphasizes leveraged finance in secondary mortgage markets. The fund primarily invests in residential mortgage-backed securities with funds borrowed via reverse repurchase agreements.

The inverted U.S. yield curve has impacted Dynex Capital by diminishing the spreads between its asset base and amalgamated liabilities. Dynex’s first-quarter results communicated a 5.28% yield on its residential mortgage assets, which span nearly 97% of its portfolio. Although DX’s asset yield might seem compelling, Dynex’s liability-weighted average rate settled at 5.46%, leading to a quarterly loan book loss of $3,192.

Repurchase rates have receded since Dynex’s latest reporting period. Moreover, the fund has a respectable price-to-book ratio of 0.92x and a forward dividend yield of 12.82%. Therefore, a bullish case holds validity. Nevertheless, I believe Dynex’s negative earnings and high funding rates present significant headwinds, which is why I am bearish about its prospects.

Fidelity Long-Term Treasury Bond Index Fund (FNBGX)

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The Fidelity Long-Term Treasury Bond Index Fund (FNBGX) is an open-ended mutual fund that tracks the Barclays Capital Long Year U.S. Treasury Index. It primarily invests in U.S. Treasury securities with durations north of 10 years, providing investors with particular term exposure. In essence, this is a systematic vehicle.

From a pricing perspective, the inverted U.S. yield curve means longer-term bonds are better suited than short-term bonds. Moreover, longer-term U.S. bonds are considered a safe haven, adding allure to FNBGX’s optics.

Despite the aforementioned positives, risks remain en masse. For example, an upward shift in the yield curve might void the pricing benefits FNBGX experiences from an inverted curve. Sure, FNGBX’s dividends will increase contemporaneously. Nonetheless, a volatile pricing environment defeats the purpose of this risk-off vehicle.

FNBGX has a 30-day yield of 4.86% and a net expense ratio of merely 0.03%. However, as mentioned before, an elevated interest rate environment might upend its risk-adjusted return benefits. As such, I’m bearish about the Fidelity Long-Term Treasury Bond Index Fund’s prospects.

iShares iBoxx $ High Yield Corporate Bond ETF (HYG)

Corporate Bonds

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As its name communicates, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) is an exchange-traded fund (ETF) that invests in high-yield bonds. Managed by BlackRock (NYSE:BLK), the HYG ETF invests in global high-yield bonds with maturities of less than 15 years. Additionally, it has a currency overlay to ensure investors are protected against foreign exchange risk.

HYG might seem like an odd inclusion to some, as credit spreads and interest rates theoretically have an inverse relationship. However, I believe a departure from that relationship is set to occur. Although inflation remains resilient, rising credit risk is unfolding as leveraged loan default rates have increased in recent months. Moreover, U.S. non-financial company interest coverage ratios are flimsy, given the uncertainty of corporate earnings.

I admit that the abovementioned argument is merely a probability. However, it might eventually affect the HYG ETF, resulting in pricing pressure. Although HYG ETF’s trailing dividend yield of 5.95% suggests it presents a robust income-based profile, heightened pricing risk might void the vehicle’s income-based benefits.

I’m overall bearish on HYG’s prospects.

On the date of publication, Steve Booyens did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Steve Booyens co-founded Pearl Gray Equity and Research in 2020 and has been responsible for cross-asset research and PR ever since. Before founding the firm, Steve spent time working in various finance roles in London and South Africa. He holds an MSc in Investment Banking from Queen Mary – University of London. Furthermore, Steve obtained his CFA Charter on April 26, 2024, and is working toward his Ph.D. in Finance. His articles are published on various reputable web pages such as Seeking Alpha, TipRanks, Yahoo Finance, and Benzinga. Steve’s articles on InvestorPlace form an interesting juxtaposition between mainstream opinion and objective theory. Readers can expect coverage on frequently traded stocks, REITs, fixed-income funds, CEFs, and ETFs.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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