How Safe Are Your Bond Funds?

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Bill Gross has left PIMCO, 5 things that could cost you now!

Do you own bond funds? Many investors and savers have flocked to bond mutual funds in their portfolios in the last 5 or 10 years, especially after the big stock and real estate drop in 2008. With bank rates on savings accounts and cd’s so low, it seemed to make sense to move that money into bond funds. After all, bonds are “safe” and you hardly earn any interest on bank based savings these days. If you went into bond funds for safety it’s probably time to take a second look! Here are 5 things you need to know about your bond funds.

1. The only day your principal is guaranteed is the date the bond matures. Bonds are valued every day. As interest rates rise and fall, so does the price of your bonds. If interest rates rise, the value of your bonds will fall. The guaranteed value of a bond is the value on its date of maturity. Since interest rates are so low, many analysts think that rates will go up in the future. If that happens, the value of your bond fund will usually drop. The question is; by how much?
2. Did you know that bond funds never mature? Since mutual funds buy and sell assets all the time, they usually don’t hold a bond until it matures, therefore the fund itself doesn’t mature. This eliminates one of the best reasons to own bonds, the guarantee! Putting money into a bond fund does not mean you can’t lose money.
3. Bill Gross left Pimco, does that matter to me? Bill Gross managed the largest mutual fund in the country, Pimco Total Return. If you have a 401k, variable annuity or larger mutual fund account, there is a good chance you own some of this fund. Just because a manager leaves a fund is not a reason to sell. It is a reason to pay attention and be cautious. I would not recommend that you add to positions in any fund that has a big manager change, until you see how it is doing with the new managers.
4. What kind of bond fund do you own? With interest rates near all-time lows, U.S. Treasury bond funds aren’t providing much yield. This has caused folks to go into things like high yield bonds, mortgage bonds and other riskier bond categories in order to get more interest. This has caused the “spread” or “risk premium” for riskier bonds to recently hit the lowest point in the modern history of the bond markets. When someone buys a riskier bond they should get a higher interest rate to compensate for the higher risk of default. There is a long term relationship between the interest rates for so called “junk” bonds and treasuries. The last time the spread was anywhere near this low was in 2007 and the market for high yield corporate bonds dropped dramatically soon after. Over the last 30 years the same thing happened whenever the spreads narrowed. Many general bond funds like Pimco have added riskier bonds to the mix in order to increase yield. Make sure you know what is in your fund.
5. What are your funds really worth? The SEC has been investigating Pimco Total Return ETF for inconsistencies in how they price their bonds. There are other funds being looked at as well. Unlike stocks, bonds don’t trade on an exchange (except for U.S. Treasuries). Therefore, when a mutual fund is pricing Municipal Bonds, Corporate
   Bonds, Emerging Market Bonds, etc. the manager uses a formula to estimate the value of the bonds held. This is because mutual funds have to publish a value every day. Since, other than treasuries, a given bond may only trade occasionally, (sometimes not for months) the manager has to estimate their price in order to publish a share value each day. This means your share value may be more of an estimate than an accurate measure of the true value of what is being held in the fund.

Given the high level of stocks and memories of 2001, 2008 and other times of stock market declines, there is a strong desire of many investors to look to bonds to reduce risk and volatility in their portfolios. Over the last 35 years interest rates have gone from double digits in the late 70’s to near zero today. This has made bonds into a relatively safe haven and produced solid returns. Unfortunately, with rates this low, there appears to be more room for them to rise than fall. I encourage you to take a moment and review your bond funds and what they are holding.

There is good reason to want to diversify and reduce risk and volatility. Bond funds may not be the answer in today’s environment. If you would like to examine your holdings, or investigate alternatives that will thrive in a rising rate environment, contact us and we can discuss ways to avoid this potential risk to your wealth.
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