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Why You Need To Be Careful With Bond Funds

Not all investors understand the inverse relationship that exits between bonds and interest rates; the fact is when interest rates rise, bond values go down.  To understand this concept let’s break this down to see how a bond works. 

Bonds have a stated maturity and a stated interest rate that they declare when they are issued.  The most common types of bonds today are government and corporate bonds.  Let’s say for example that you purchased a $10,000 corporate bond that pays a 3% interest rate and it has a 10 year maturity.  Now, if you hold the bond to maturity, then you will get the original $10,000 back and you will also receive the 3% stated interest each year. No problems so far…

Now, let’s say that during the 10 year period that market interest rates go up and the same corporate bond is now paying 4% and the next year it goes all the way to 5%.  You still own your 3% bond and you may be wanting to either cash it in to get a higher rate or maybe you just didn’t want to hold the bond for 10 years. What happens now?

Here’s an important fact: on a 10 year bond for every 1% rise interest rates the VALUE of your bond will go down by nearly 10%! So, in this example since rates rose by 2% the underlying value of the $10,000 bond would drop to approximately $8,000.

Here’s another important fact. The longer the maturity date of the bond the more it will drop when interest rates rise. For example a 30 year bond will drop nearly 20% for every 1% increase in interest rates, so in the above example a 30 year bond could lose 40% in value.  Guess what?  Do you think you will actually hold a bond for 30 years before cashing it in? Will you live that long?

Let’s see how this works and look at it in simplistic terms.  I’m looking to invest $10,000 into a corporate bond and the newly issued bonds are paying 5%.  You have a 3% bond and are looking to sell the bond before maturity.  The only way that I would buy your bond is if I get it at a discount so that the lower interest rate that your bond is paying will equal what I could get for a new bond.

Bond Funds Get Worse

One good thing is if you hold an individual bond is you can hold it to maturity and get back your deposit, even if you had to settle for lower than the market rate of interest for a period of time.  Not so with bond mutual funds!

With a mutual fund the underlying assets within the fund have an underlying value that fluctuates daily called the NAV or Net Asset Value.  This is what determines the value of your investment, so when interest rates go up, you automatically will lose value within a bond fund.  The bond fund will hold many bonds all with a  particular style, such as government, or corporate, and will vary slightly on the duration. Again, the longer the duration of the bonds within the fund the greater the losses when interest rates increase.

Here’s the problem: Within the majority of investment portfolios either individual bonds or bond mutual funds are used to reduce risk.

Where are We Today?

Over the past 30 years using bonds has worked out well since interest rates have go down and bond values have increased.  But now that the Federal Reserve has started to raise rates over the last few years we are actually seeing the beginning of what many experts feel will be a prolonged bear market for bonds as market interest rates steadily increase.

What Should an Investor Do?

If you’re going to continue to use bonds, then purchase shorter term individual bonds or shorter term bond funds. You will have to settle for lower yields, but at least the portfolio losses will much less as shorter term bond funds won’t lose a much when interest rates go up. 

Another option is to find Dynamic bond managers that can move around the bond markets to mitigate losses and still find opportunities within the various bond markets.  Our firm has identified a number of managers with this ability. This is a much better option then using a fund that just buys and holds one type of bond with similar durations.

The other option to round out a portfolio to reduce stock risk, is to use alternative types of investments such as guaranteed index annuities, MLP’s, REITS, and other similar types of investments.  Our firm has a lot of experience in this area so reach out and we will be glad to provide you with alternatives.

So, in summary find out what your bond exposure is and what is the duration of the bonds.  Some investors may find that they own 20 to 30 year bonds through their brokerage firm and they have a large amount of risk.  Right now is the time to really make sure as rate continue to rise!

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