Are Bond Funds Safe as Interest Rate Rise?

 

Jane Young, CFP, EA

Jane Young, CFP, EA

A key tenant in properly managing your investments is to maintain a well diversified portfolio.  A well diversified portfolio usually contains a mix of stock or stock mutual funds and fixed income investments.  Stock mutual funds are long term investments that can provide you with growth over a long period of time. Fixed income investments can provide you with short term liquidity, income, and a buffer against stock market volatility.  Bond funds have long been a staple in most fixed income portfolios.  However, with the threat of rising interest rates, many bond funds may no longer provide the stability you are seeking in the fixed income sleeve of your portfolio.

Interest rates, after dropping close to all time lows, have begun to increase.  The bond market had experienced what is commonly referred to as a 30 year bull market. Until recently, interest rates had been steadily dropping since the 1981.  As interest rates fell, bond owners experienced a corresponding increase in the value of their bonds.  Generally, when you buy a bond and interest rates decrease, the market value of the bond will rise. On the other hand, if interest rates increase, the market value of the bond will drop.  If you hold an individual bond to maturity, assuming the issuer does not default, your entire principal will be returned, regardless of the prevailing interest rate. 

Many investors prefer bond mutual funds over individual bonds because they provide greater diversification, liquidity and professional management.  However, recently bond funds have experienced decreasing yields.  As bonds within mutual funds mature, they are replaced with lower earning bonds.  In an environment of increasing interest rates, another major concern is the potential loss of principal.  If many investors decide to sell their bond funds, the fund managers may be forced to sell individual bonds at an inopportune time.  The manager may be forced to sell bonds before maturity, at less than the face value.

The duration of a bond fund is a measure of it’s sensitivity to changes in interest rates or interest rate risk.  For example, if the duration of a bond fund is 5 years, and interest rates decrease by 1%, the value of the bond fund should rise by about 5%.  If interest rates increases by 1%, the value of the bond fund should drop by 5%.  Short term bonds have a lower duration and long term bonds have a higher duration.  You can find the duration of most bond funds at Morningstar.com.

With the threat of higher U.S. interest rates, consider moving your longer term bond funds into short term bond funds or international bond funds.   For greater security of principal, move your bond funds into an FDIC insured CD ladder or equity indexed CD.   Bond funds usually represent the safe portion of your portfolio,  and some of your principal may be at risk as interest rates rise.

Are Your Bonds Safe?

 

 

 

 

 

 

Jane M. Young

Let’s compare some differences between stocks and bonds.  When you buy a bond you are essentially lending money to a corporation or government entity for a set period of time in exchange for a specified rate of interest.  When you invest in the stock market you assume an ownership position in the company whose stock you are purchasing.  As a result, the value of your investment will fluctuate based on the profit or loss of the underlying company.  With the purchase of a bond the value of your investment hould not fluctuate based on the financial performance of the issuer, assuming it remains solvent.  You will continue to receive interest payments according to the original terms of the agreement until the bond matures.  Upon maturity the amount of your original investment (principal) will be returned to you along with any interest that is due.   As a general rule, stocks are inherently more risky than bonds, therefore investors expect to receive a higher return.

Bonds may appear to be safe but they are not without risk. Currently, there is some risk associated with low interest rates that may not keep up with inflation.  This is especially true with many government bonds. Two additional risks typically associated with bonds include default risk and interest rate risk.

Default risk is the risk that the issuer goes bankrupt and is unable to return your principal.  Most bond issuers are assigned a rating to help investors assess the potential default risk of a bond.   Generally, investors are compensated with higher interest rates when taking a risk on lower rated bonds and receive lower interest rates on higher rated bonds.

Interest rate risk is based on the inverse relationship between interest rates and the value of a bond.  When interest rates increase the value of a bond will decrease and when interest rates decrease the value of a bond will increase. If you hold an individual bond until maturity your entire principal should be returned to you.  You have the control to keep the bond until maturity and avoid a loss.  However, if you need to sell before maturity you may lose some principal. The loss of principal is greater for longer term bonds.  This needs to be weighed against the benefit of a higher interest rate paid on longer term bonds.

Bond mutual funds can provide diversification and reduced default risk because your money is pooled with hundreds of other investors and invested in bonds from a large number of different entities.  If one or two entities within the mutual fund go bankrupt there will be minimal impact on each individual investor.  However, with mutual funds you have less control over interest rate risk.  When interest rates increase, bond fund managers often experience a high rate of withdrawals forcing them to sell bonds at an inopportune time.  This usually results in a loss of principal, the severity of which is greater for longer term bond funds.

Living Dangerously in the World of Fixed Income

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Jane M. Young CFP, EA

It is important for us to stay diversified and keep a prudent amount of our portfolio in fixed income investments – but where? We can avoid interest rate risk and default risk with CDs; however, we may sacrifice on return. Currently most short term CDs are paying less than one percent. We can get a slightly better return for a longer term CD but does this make sense in such a low interest rate environment? With CDs, the biggest downfall is the lost opportunity for a higher return.

If you want a higher return and you are willing to take some additional risk, consider short term bond funds. A short term bond fund that invests primarily in treasuries and government agency bonds has a very low default risk. However, there is some interest rate risk. Interest rate risk is due to the cause and effect relationship between bonds and interest rates. When interest rates rise, after the purchase of a bond or a bond fund, the value of the bond will decrease. For example, you purchase a $20,000, 10 year bond that pays 3% interest. A few years later interest rates go up to 5% and you decide to sell your bond that only pays you 3%. When you try to sell your bond you can’t get $20,000 for it because it pays 2% less than the market rate. However, several buyers may be willing to buy your bond for a discounted value to make up for the lower than market interest rate. If you hold your bond until maturity it should sell for the full purchase value of $20,000. The inverse is also true, if interest rates go down your bond will be worth more than what you paid. The degree to which this occurs is magnified by the term or duration of the bond. Short term bonds have less interest rate risk than do long term bonds.

Default risk is the risk that the company or entity issuing the bond will be unable to pay you back. In essence a bond is a loan made to a company or a government entity for a specified interest rate over an agreed upon period of time. US Government bonds and bonds backed by the US Government have an extremely low risk of default. Corporations, Municipalities, and other governmental entities have varying degrees of risk depending on their financial stability. Most bond issuers are assigned a rating to help investors assess the potential default risk of a bond.

A mutual fund has less default risk than an individual bond because you are buying an ownership share in several different bonds. However, you have less control over interest rate risk. If you own an individual bond you can hold it until maturity. If you own a mutual fund, the fund manager may be forced to sell bonds at an inopportune time due to a high rate of withdrawals. If the fund manager could hold all of the bonds to maturity there would not be an actual drop in value. However, bond funds must reflect a share price based on the current value of the bonds held in the portfolio.

If you want a higher return you may want to consider intermediate term bonds but be prepared for a corresponding increase in the level of interest rate risk. If you want to maximize return you could consider high yield or junk bonds. However, be very careful in this arena because high yield bonds are subject to both interest rate risk and default risk. In the current environment, interest rate risk and default risk are very high. Unless you are an expert in high yield bonds, this is a lot of risk to take on the portion of your portfolio that is designed to be less risky and serve as a buffer against the stock market.

Most of my clients are best served by investing in a combination of CDs, high quality short term bonds, and some high quality intermediate term bond funds. Unfortunately, there are few really good options in the current fixed income market.