When Do Bond Funds Become Risky?

When Do Bond Funds Become Risky?

I’ve long been an advocate for more transparency in investor portfolios. Over the years, I have seen numerous investors who walk into my office and have no idea how their previous advisors had managed their money.

When I ask them what their previous advisor’s strategy had been, the response I often get is “my advisor has me diversified and tells me to hold on for the long term”. That advice may have worked back in the 90’s when the stock market went nowhere but up, but nowadays that is some very dangerous advice.

Investors today need to have a better understanding of how their investment portfolios are managed. The old “pie chart diversification model” isn’t a good answer. Instead, investors should understand when, why and how investments are allocated before a single dollar is invested. Now, I’m not suggesting that clients need a detailed report every time the market goes up or down a hundred points, but they absolutely should know how and when the portfolio is rebalanced during times of increased market risk. For example, in my ARTAIS strategy, we have very specific and structured guidelines for when and how much we invest in particular sectors of the market, and provide clients with a detailed written investment strategy so there is no question in their minds as to how their money is being managed.

Ideally, during times of extreme downturns in the market, an investor should be able to say “I know exactly what my advisor is doing because we have already discussed this scenario when we set up the portfolio.” Many clients of traditional brokerage firms, however, find themselves calling their advisors after they’ve lost a ton of money, only to have the broker pitch them on the firm’s “newest” ideas to deal with the crisis. This is not a good way to do business.

Why am I bringing this up now? Because there is a potential time bomb ticking away that needs to be addressed.

When Do Bond Funds Become Risky?

Over the past few years, as the stock market has become more volatile, investors have shifted the mix of their portfolios to include more bonds. Some have moved money into bond mutual funds for either income, perceived safety (which I am going to address in a moment), or to chase the positive rate of returns that many bond funds have produced over the past few years.

alternative to mutual funds

The ticking time bomb are bond funds. Many investors do not fully understand how they 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. Actively managed bond funds can alter maturities, credit qualities and other characteristics of their funds to take advantage of perceived market inefficiencies. Unlike individual bonds, bond funds are not managed to a fixed maturity date.  As a result, bond fund performance tends to reflect the overall level of interest rates during the period the fund is held. By contrast, the performance of an individual bond is equal to the yield to maturity at which it was purchased, adjusted only by the reinvestment rate of coupons.

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

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What about the Fed’s policy to keep rates low? The Fed is focused on keeping short-term rates as low as possible, while most bond funds invest in long-term bonds (where there is more volatility and chance for greater market gain). There are two scenarios that bond fund investors should worry about:

1) A rising stock market: If we can get a year or two of strong gains in the stock market then investors may start to reallocate their portfolio from bonds to stocks. As they sell their bond holdings, bond prices will go down and interest rates will rise due to the inverse nature of how a bond works. Investors who have allocated most of their portfolio to bond funds will get hurt.

2) Continuing global problems: If the global economy continues to falter, then bond investors will want to be paid a higher interest rate. The higher debt loads in various countries and corporations will be viewed as higher risk for bond investors. We have already seen this happen in some countries in Europe. In this scenario bond funds that hold bonds of these countries are getting hurt.

 

So, if your current investment strategy is based on “pie chart allocation” and “hold on for the long run”, you may want to better understand what exactly is in your portfolio. A typical allocation that is recommended by brokerage firms is the 60/40 split. 60% in bond funds; 40% in equity funds. This allocation can (and has) proved disastrous to many of their clients’ portfolios. Think about it this way — will you be able to retire if 60% of your portfolio loses half its value?

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