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Bond Funds-Safe Haven or Risky Asset?

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Municipal bond issued in 1929 by city of Krakó...

A recent article on the Market Watch website indicated that 90% of the $226 billion that has flowed into mutual funds this year through August went to taxable and municipal bond funds. This trend has continued despite a tremendous rally in the equity markets since early March.

What is driving this flow of dollars to bond funds? A few thoughts:

Yields on money market funds and CDs are anemic. Some money funds are at or close to a negative yield.

Many investors are still risk averse after the stock market’s precipitous drop from September of ’08 to the current low in early March.

The “Lost Decade” effect. Through August, the Barclay’s Aggregate Bond Index gained an average of 5.98% per year for the trailing ten years. The S&P; 500 Index by contrast lost 2.22% per year over the same time period.

Money follows performance. Investment grade bond funds have performed well so far in 2009.

Are bond funds a safe haven or do they carry risk? The answer is both. Over time bond funds have been less volatile than stock funds, but that doesn’t mean that losses cannot occur.

Investors in a number of top bond funds in 2008 learned about risk the hard way. Even a well-managed fund like Loomis Sayles Bond lost 21.82% in 2008. The losses here and in other similar bond funds were a combination of some risky holdings and the fact that any bond that wasn’t a Treasury took it on the chin in 2008.

Years like 2008 aside, the biggest risk in bond funds stems from the potential of rising interest rates. A basic fact about bonds, the price of an underlying bond moves inversely with interest rates. When rates rise, everything else being equal, the price of existing bonds (and the bond funds holding these bonds) will drop.

Bonds have been a relatively good investment over the past ten years and beyond due in large part to a general trend of falling interest rates. With interest rates at historic low levels, at some point there is no place for them to go but up.

Morningstar and other services track a statistic called duration. Duration is a calculation that takes into account the interest paid by a bond and the number of years remaining until the bond matures. Duration is a measurement of the interest rate sensitivity of the bond, or in this case the bond fund. Looking at the duration of three Vanguard bond index funds:

• Vanguard Short-Term Bond Index 2.62 years
• Vanguard Total Bond Index 4.27 years
• Vanguard Long-Term Bond Index 11.59 years

Duration is an approximation of the impact on the fund’s value of a 1% change in interest rates. By this measurement, a 1% increase in interest rates would translate into an 11.59% decrease in the share price of the Vanguard Long-Term Bond Index Fund. You can check the duration of most bond funds at www.morningstar.com.

My point is not to discourage investors from holding bond mutual funds. Bond funds provide diversification and can dampen the volatility of an investment portfolio. Rather my purpose is to ensure that investors understand the risks posed should interest rates increase in the future.

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Comments

  1. Roger, excellent post about bond funds! Thanks,
    Cathy Curtis

  2. Cathy, thanks for your comment. The amount of money that continues to pour into bond funds is astounding. I hope that investors understand the risks should interest rates increase and should inflation creep up.

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  1. […] September of 2009 I wrote Bond Funds Safe Haven or Risky Asset thinking that interest rates were headed up in the near future.  I wrote an update of this post in […]

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