Bond Funds Might be Hazardous to Your Wealth

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Do you own any Bond Funds? And if you do, why?

For most folks, the answer is they want to reduce risk and volatility in their investment portfolio. For many, they are concerned that stocks may be in for a correction sometime, and just are afraid to lose 25% or more again (remember 2008?), so they moved out of stocks and into bonds.

After All, Bonds Are Safe, Aren’t They?

Let’s take a look.

For more than 35 years, since interest rates topped out in 1980 (money market funds paid 18%+ in those days), whenever stocks started to go down, investors could move into bonds and they were rewarded.

See, when interest rates go down, the price of existing bonds goes up. So folks would make this switch and their bonds would go up in value and then when markets calmed down, they would sell their bonds and go back to stocks, pocketing a nice capital gain, in addition to the interest they had earned. For example, when the S&P500 went down 22% in 2002, the Barclays Aggregate bond index gained 10.26%!

Do Bonds Reduce Volatility and Help Avoid Risk?

When we get used to this type of pattern, it becomes almost a mantra; “bonds reduce volatility and help me avoid risk”. However, if rates were to increase instead of what I described above, the opposite would be true, the value of bonds will go down.

Back in 2016, interest rates hit bottom in July of that year, 1.36% for the 10 year treasury bond, one year later the rate in 2017 was up to 2.38%. During that time, the iShares U.S. Treasury Bond ETF lost 4.25%!

Many other bond funds, and ETF’s, especially those that hold lower rated bonds, lost even more. This was like a wake up call as to what can happen in a short time, if interest rates increase.

If that were to happen over a longer period, the losses could be substantial. Since the 5 year annualized return for this fund is only 2.05%, racking up that kind of loss would potentially wipe out 2 years of growth.

Not All Bonds are Created Equal

When I talk with clients, most people think that all bonds are “safe”. In fact there are many different types of bonds from super safe U.S. Treasury bills, notes and bonds, to much riskier corporate “high yield” bonds that we used to call “Junk Bonds”.

If you recall the Savings and Loan crisis of the early 1990’s you may recall that event was largely brought on by these kinds of junk bonds defaulting when the economy went into a recession during that period. In fact today there is a record amount of outstanding corporate debt outstanding.

Fully 49% of that debt, according to rating agencies, is rated BBB. This is the lowest rating that is considered, “investment grade”. If they were to be downgraded at all from that (eg. BB), they would end up classified as “high yield” or “Junk”. If we were to have a recession, these types of downgrades are likely.

This would force many investment pools, mutual funds, pension plans and other owners to sell as their investment rules do not allow them to own “non-investment grade” debt. When selling comes into a relatively illiquid market, prices can drop dramatically. This can ignite a spiral down in values like we saw in 1990-1991 and 2007-2010.

One of the big concerns about this market is that over half of the currently outstanding corporate debt needs to be refinanced between 2021 and 2025, and there is concern that lenders (investors) appetite for this type of risk might not be as large as it has been. This could  result in downgrades and defaults. It could also result in higher interest rates being paid to attract investors. As we discussed before, when interest rates rise, the value of bonds go down.

So are You Saying “Don’t Buy Bonds”?

That isn’t what I am saying. All bonds still have a date at which they mature and on that date,  you know exactly what the bond will be worth (provided the issuer doesn’t default). This is the guarantee that bond investors point to when they are looking to reduce risk. After all, you have no idea what a share of stock will be worth at any date in the future, with a bond, you have that assurance on a specific date.

What I am saying is that bond funds do not enjoy this guarantee of value. Bond funds of all types buy and sell bonds all the time. Because of that fact, the bonds being held in the fund are not usually held to their maturity. So when interest rates rise their value falls. Also if credit quality falls, their value will go down.

OK, I Get it, is There Anything Else?

There is one more factor that I think is even more impactful to investors than what I have mentioned above. The fund sponsor can’t be sure what the bonds in the fund are worth!

If you invest in a treasury bond fund, you can be much more confident that the share price of the mutual fund is a fair representation of the actual value of the underlying bonds. This is because U.S. Treasury bills, notes and bonds are widely traded daily. Since all the bonds of a similar maturity are the same, investors know exactly what they are buying and the amount of this debt that trades every day dwarfs the volume of all the stocks traded in a day. Just like with widely held stocks, you can have a high degree of confidence in the published value since there are so many transactions every day.

What’s the Difference Between Corporate Bonds, Municipal Bonds or Special Use Bonds?

The provisions of these kinds of bonds may vary, even by the same issuer. Additionally, these bonds are part of a market that isn’t all that liquid. A particular Corporate or Muni bond may only trade a few times a year. However, the fund must provide a value each day so that investors can redeem their shares (we are only discussing open ended mutual funds in this post). Often, that valuation amounts to an “educated guess”.

I wrote about safe bond funds a few years back. If a lot of folks try to redeem at the same time, those “guesses” at valuation could cost investors a lot of money and accelerate losses even more!

There are many forces gathering in the bond market beyond what I have discussed here. If you are looking to reduce risk in your portfolio, I would agree with your objective and reasoning, especially if you are going to be retiring in the next 5-10 years.

I want you to know that there are alternatives to bond funds that avoid the risks we have outlined here, that would succeed in reducing overall volatility in your portfolio. Many of those options will also benefit from rising rates, instead of being hurt.

If you would like to see what kind of risk is in your bond funds, or just want to learn about alternatives, give us a call at (415) 331-9030 to set up a free consultation. We are happy to help.
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