If your portfolio includes a broad-based bond index fund, you’ve probably noticed its value has fallen significantly over the past several weeks. Judging from recent e-mails I’ve received, the reasons for this decline are not always clear, so let’s take a closer look.

Most investors understand that when interest rates rise, bond prices fall. But there are many different interest rates, and they all affect your bond fund in different ways. The shortest of short-term rates is the target for the overnight rate, which is set by the Bank of Canada to control monetary policy—in other words, to keep inflation low. This rate influences the prime rate banks use to price variable-rate mortgages and lines of credit, so it’s the one most widely discussed in the media.

The Bank of Canada has kept the target rate at 1% since September 2010: that’s more than 32 months, the longest period it has ever remained unchanged. Meanwhile, the prime rate has held firm at 3% during this same period. I’ve been asked by some investors why they’ve seen their bond holdings fall when “interest rates haven’t gone up.”

But as I’ve mentioned, this short-term benchmark is only one of many interest rates. The yields on two-year, five-year, 10-year and longer-term bonds move independently of the target rate, and these are the rates that affect your bond index fund. They’re rarely reported in the financial media, but you can follow them on the Bank of Canada’s website.

The chart below shows the yield on several benchmark Government of Canada bonds over the last two months:

Interest rates

Notice that all of these rates moved upward in May, and the steepest line belongs to 10-year bonds, which have seen yields jump from 1.68% at the beginning of the month to 2.07% on May 29. As a result the iShares DEX Universe Bond (XBB), the BMO Aggregate Bond (ZAG) and the Vanguard Canadian Aggregate Bond (VAB), all which have an average term of about 10 years, saw their market prices fall significantly during the month:

Bond prices

The price is only half the story

There’s another extremely important point to understand. Whenever you look up bond ETFs using a tool like Google Finance, as I did above, the results are highly misleading. These charts show only the change in market price, not the interest payments paid to investors in cash, so they do not reflect the total return of your bond ETF.

These days, with virtually all bonds trading at a premium, you should expect the market price of your fund to fall even if interest rates hold steady. However, the cash payments from the underlying bonds are in the neighbourhood of 3% to 3.5% for broad-based index funds, which will offset at least some of that price decline. Indeed, the three ETFs above each delivered a total return of more than 1.5% during the 12 months ending in May, even though their market prices fell considerably during that time.

Remember this when you look at your brokerage statement. Say you bought ZAG on May 31, 2012, and paid $15.96 per unit. Exactly one year later its price was $15.70, so your statement would show a loss of –1.63%. However, the fund’s total return over that period was +1.62%, because the interest payments more than offset the price drop. You didn’t lose money, even though I’m sure some investors thought they did.

An individual fund’s total annual return never appears on your statements, so you should periodically visit your bond fund’s website to see how it’s really doing. Click the “Performance” tab to see the total return on the fund including price changes and reinvested interest payments. Here’s what they look like for ZAG:

ZAG performance

If yields continue to rise, bond funds can and will deliver negative returns even after accounting for interest payments, so you should be prepared for that. Remember why bonds are in your portfolio: they lower overall volatility and provide a cushion when equities inevitably suffer a downturn. If bonds do have a difficult year, that’s not a reason to abandon them: it’s an opportunity to rebalance.