Should I Own Bond Funds Now?

bond-funds

Many Bond Funds are Under Pressure Today. If you own bond funds, you need to read this now!

Why do you own a bond fund? If you are like most folks that I talk with, it is because they are looking for some safety with their investments. After all, bonds are much safer than stocks, aren’t they? The only true answer to that question is; it depends! Safety in the bond market depends on how you own your bonds and what kind of bonds you own. The element that creates the perception of safety is the guarantee included in a bond. What most folks forget is the Guarantee on a bond‘s principal is only for one day!  That is the day the bond matures. Until that day, the only thing guaranteed is the interest payment. The value of the actual bond will go up and down every day. For today’s discussion I am going to look specifically at bond mutual funds.

Given today’s economy and how the markets are responding, you may have already lost some money in your bond mutual funds. If you own certain bond funds, the losses may be more than 10% and you could be in for even greater losses. I wrote about bond mutual funds last October, and I suggested then that it was time to look into these funds and consider alternatives. Since that time, most funds have returned less than one percent, and many have negative returns. If you have High Yield funds (Junk Bonds), you are probably down 5% or more!

Let’s take a look at the main categories of bond funds and the risks presented by each. (I am only going to look at domestic bonds for this discussion)

First, let’s look at U.S. Treasury funds. With interest rates near all-time lows and the Federal Reserve poised to increase rates, the value of treasuries will drop if bond rates rise as a result. Since bond mutual funds rarely hold a bond to maturity, the value of the bonds in the portfolio will drop in value which means that the share price will drop. Depending on the average maturity in the portfolio, a 1% increase in treasury rates could translate to a drop of 10% or more.

Second, investment grade corporate bonds. Funds with this type of bond will generally react like treasuries.

Third, let’s look at municipal bond funds. Many investors, especially in high tax states like California, like these funds because they earn interest “double tax free”. While the Muni market is relatively healthy at this time, many of these double tax free funds include bonds from Puerto Rico, which receive double tax free status in all states. Puerto Rico is considered by many to be on verge of default. These bonds have been losing a lot of value over the last few months. Check with your fund to see what your exposure is to these, you might be surprised at how many of these are in your California or New York double tax free fund. These funds will also lose money if rates were to increase on Municipal bonds in general.

Fourth, and most urgently, are the High Yield Corporate Bonds. There has been a huge amount of these sold in the last 4 or 5 years as investors wanted the higher interest that these pay relative to investment grade bonds (both corporates and treasuries). Almost all of these funds have lost more than 4% in the last year and some funds have lost more than 10%. Many of the bonds sold in the last few years were issued by oil, mining and other capital intensive commodity based companies. If you have seen what has happened to oil and other commodity prices over the last 6 months or so, you know that many of these companies are starting to have problems paying their bills. If oil prices remain low, there is a lot of fear that there might be a lot of defaults in this area. As a result, prices are dropping and could drop much further. These bonds trade more like stocks than bonds. If you own them, it is imperative that you understand the difference.

Finally fifth, there are Total Bond Market funds or Income funds. These funds can include all of the types of bonds listed above. These funds can include all of the different risks we discussed above. These can also include emerging market and other foreign country bonds. Since rates are currently even lower in much of Europe, the risk of loss to increasing rates might even be greater than in our domestic markets.

To wrap this up, Bonds are generally included in a portfolio in order to reduce the risk of the portfolio. Bond funds are probably not going to provide that protection if you include bond mutual funds in your investment mix!

The good news is that there are alternatives that can provide the same or greater guarantees, yield more interest than bonds of similar risk and actually benefit from increasing rates, without the loss of principal one would experience with a bond mutual fund. If you would like to hear about ways to achieve the risk reduction you are looking for, without the risk of losing principal to rising interest rates, contact us and we can see if any of these alternative strategies are right for you.

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  1. […] to keep it to maturity, investment grade bonds are guaranteed to lose value. This is why I have previously warned readers about bond mutual funds and the fact that they will not protect you from losses in a rising interest rate environment. If […]

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