Risk Ahead - How Risky Are Bond Funds?

Risk Ahead – How Risky Are Bond Funds?

 

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Why Worry Now About Bond Funds?

Since the early 1980’s, interest rates have been on the decline and are now at historic lows.

However, some investors are worried that we may be on the verge of a reversal in trend as the US Federal Reserve (aka the Fed) continues its program of tapering the Fed’s purchase of US Treasury bonds. (Remember: the Fed controls short term rates, while the market controls long term rates.)

are bond funds risky now

While retirees typically use bonds as a fixed income source, most investors use bonds as part of an asset allocation strategy.

Unlike retirees who are looking for a steady and safe income stream, bond fund investors are looking for overall investment performance and portfolio diversification.

As a result, retirees will be happy to see higher interest rates, but investors who are using bond funds for diversification purposes should be aware of what happens to bond funds in a rising rate environment.

Select Fund Performance During Past Rising Rate Periods  
Fund Name10/14/93 - 11/18/9410/2/98 - 1/21/00
Pimco Total Return Fund -Inst-14.70%-12.20%
Vanguard Total Bd Mkt Indx - INV-12.40%-9.70%
Templeton Global Bond Fund - A-11.60%-12.80%
Vanguard S/T Invest Gr-Inv-6.30%-4.50%
Vanguard GNMA Fund - Inv-8.60%-8.10%
Vanguard Intm Trm T/E Fd - Inv-10.50%-7.10%
The Bond Fund of America - A-15.70%-6.10%
JP Morgan Core Bond-Sel-17.40%-9.90%
Dodge & Co Income Fund-13.60%-8.70%
Loomis Sayles Bond Fund - Ins-15.10%-6.80%

source: Bloomberg

Inverse Relationship: How Bonds Work

Today, the majority of bonds provide investors with a defined amount of income at regular intervals, usually twice a year. This is typically referred to as the coupon rate or interest rate of the bond.

There is a fixed maturity date, and as a bond investor you would receive interest payments for the life of the bond. At the expiration date of the bond (for example 10 years) the bond’s principal is returned to you.

By calculating a bond’s future interest payments, it is possible to derive a total return, or yield to maturity. This yield is the annual return on your initial investment though the life of the bond.

Interest and principal payments are determined by the issuer’s creditworthiness. A higher yield implies a higher risk of the bond defaulting and thus not delivering on future coupon payments and, in some cases, the principal as well.

In other words, you are paid a higher interest rate for taking on more risk.

Since you are paid a fixed rate for the life of the bond, changes in market interest rates will cause bond values to fluctuate.

For example: investors who paid $1000 for a bond with a 3% coupon rate can resell their bond for a greater value when interest rates fall. This is because newly issued bonds will sell for $1000 with a smaller (for example a 2.5%) coupon rate.

bond prices vs rising interest ratesSource: Riverbend Investment Management

The opposite occurs when interest rates rise, and this is where the risk lies for bond fund investors.

Bond Fund Risk: How Bond Funds Differ From Individual Bonds

Building a portfolio of individual bonds will require sufficient funds to enable you to invest across several different issuers to ensure a reasonable amount of diversification.

Generally speaking, investing in a diversified portfolio of individual bonds requires at least $100,000–$200,000, which is why bonds funds have become so popular over the past 20 years. Bond fund investors can get access to a diversified bond portfolio for $1000 or less.

However, many investors do not fully understand how bond funds work, but rather they hear the term “bond” and think safety. Well, this isn’t the case with bond funds.

The differences between a bond and a bond fund are substantial. Unlike individual bonds, bond funds are not managed to a fixed maturity date. Instead, bond funds are actively managed to take advantage of changing interest rates. Just like in the stock market, bond fund portfolio managers are trying to buy low and sell high.

However, unlike the stock market, bonds are directly impacted by changes in interest rates.

As a result, bond fund performance tends to positively correlate with the overall level of interest rates during the period the fund is held.

In other words, when interest rates rise (change of yield), bond funds get crushed:

bond fund riskrisk

How Risky Are Bond Funds? Review Your Risk

One way to do this is to look at your bond fund’s holding and duration. Short term bonds (short duration) tend to be impacted directly when the Fed raises or lowers rates. Most recently, the Fed has hinted that it expects to keep short term rates at current levels until 2015.

Bond funds with a longer duration are impacted more by market swings in the bond market, since investors with a longer holding period examine the impact of future interest rates, inflation and economic growth.

Volatility In Duration: iShares 1-3 Year Treasury Bond ETF vs iShares Barclays 20+ Yr Treasury Bond

Volatility In Duration: iShares 1-3 Year Treasury Bond ETF vs iShares Barclays 20+ Yr Treasury Bond

Additionally, bonds with lower credit ratings are more volatile than US Treasuries. Investors who are willing to take on greater risk in return for high coupon payments during rising markets should understand how fast high yield bond funds and high yield ETFs can decline compared to the traditional bond indices:

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source: Morningstar

While it is tough to forecast how the Fed and the bond market will react to future news on economic growth, now is a great time to review your investment plan to make sure that your portfolio is not impacted by rising interest rates.

Questions? Thoughts?

 

john_rothe_2Feel free to leave a comment below or you can reach out to me privately here.

– John

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