Objective information about financial planning, investments, and retirement plans

Bond Funds Safe Haven or Risky Asset? – An Update

The Frankfurt Bond Market

In 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 January of 2010 under the same premise.  This illustrates why I refrain from predicting anything.  As most of you are probably aware the Federal Reserve has continued its efforts to keep interest rates low.  At some point, however, rates are likely to rise (not a prediction).  Here are some of the factors to keep in mind if you own or are considering investing in a bond mutual fund or ETF.

Why are you investing in bonds?  Like any holding in your portfolio, you should have a reason to invest in bonds, whether via a fund or individual bonds.  Among the reasons to consider are diversification from stocks, yield, and the opportunity for growth via total return (price appreciation and income).

Using three Vanguard index funds as an example, the Vanguard Total Bond Market Index has a correlation of 0.05 to the Vanguard Total International Stock Index fund and -0.05 to the Vanguard Total Stock Market Index fund.  In both cases this means that the returns of the bond fund are virtually unrelated to those of the two stock funds over the past ten years.  A correlation of 1 between two funds would mean that they move in almost complete lockstep, a correlation of 0 means there is virtually no relationship.

Yields on investment grade bonds are down along with interest rates, many fixed income investors have moved into areas like high yield bonds (junk) or dividend paying stocks in search of current income.  Both moves will impact the risk profile of your portfolio.

Using the same three Vanguard funds, bonds have outperformed stocks over the past 1, 5, and 15 years ending June 30.

Unlike individual bonds, bond funds do not mature.  If you buy a bond that matures in July of 2022, upon maturity you will receive the value of the bond (generally $1,000) and any interest payments that are made between now July and 2022.  Neither of these payments will be impacted by the direction of interest rates.  That said the price you would receive for the bond should you decide to sell it prior to maturity could fluctuate between now and 2022.  Other factors such as call provisions or a default by the bond issuer could also come into play.

On the other hand, bond fund portfolios are perpetual in nature.  Some of the bonds in the portfolio will mature, others will be sold by the manager for various reasons, and others will be added to the portfolio.  This fluidity makes bond funds continually sensitive to interest rate fluctuations.  The return on any bond fund will be a combination of interest payments received and the gains and losses of the underlying bonds in the portfolio.

Index funds track their index.  Rightly so, many advisors and financial journalists tout the benefits of investing in low cost index funds and ETFs.  For example, the Vanguard Total Bond Market Index fund ranked in the 31st percentile (top 31%) of its peer group of funds for the trailing 12 months; the 79th percentile for the trailing 3 years; the 44th percentile for the trailing 5 years; the 41st percentile for the trailing 10 years; and the 30th percentile for the trailing 15 years ended June 30.  As you can see this passively managed fund has beaten the majority of funds in the same Morningstar Intermediate Term Bond category over most trailing periods of time.

This cuts both ways.  In 2008 the fund ranked in the 10th percentile of its category due to its benchmark index having a significant allocation to Treasuries.  In 2009 the fund ranked in the 90th percentile and in 2010 in the 73rd percentile as corporates and other riskier bonds recovered from the flight to quality of 2008.

The point is that bond index funds may be constrained when interest rates rise; where as an active manager might have more leeway within the fund’s investment policy to make trades to mitigate the impact of rising interest rates.

The future 

  • Total return of a bond fund is a combination of the price changes of the underlying holdings, gains or losses when those holding are sold, and the interest received from the individual holdings.
  • Bond prices are impacted by a number of factors:
    • The direction of interest rates.
    • Inflation, rising inflation is the enemy of most bond holders in that the interest rate payments they receive are fixed and lose purchasing power during periods of inflation.
    • The perceived ability of the issuer to make good on their promise to make periodic interest payments and to redeem the bond at maturity.
    • The time to maturity of the underlying bonds in the fund.  The longer the time to maturity, the more sensitive the bonds will be changes in the interest rate.
  • In the case of funds that hold foreign bonds, the relative value of the currency of the issuing country can impact the value of the fund if the fund does not hedge the various foreign currencies represented in the fund versus the dollar.
  • It is important to review any bond funds that you hold or are thinking of buying to try to get a feel as to the potential impact of rising interest rates on your fund. 
  • A quick way to gauge the impact is to look at the fund’s duration.  This number can be found via Morningstar and certainly in other places. 
    • For example, the Vanguard Total Bond Market Index fund has an effective duration of 5.11 years.  This means that the fund’s value would be expected to drop 5.11% should interest rates rise by 1%. 
    • Of course the fund would still collect the interest paid on the bonds held in the fund.  Morningstar lists the fund’s current yield as 2.83%
    • The Vanguard Long-Term Bond Index fund’s duration is 14.19, indicating a significant drop in value should interest rates rise. 

Going forward it is imperative that you understand both the benefits provided by your bond fund investments and the risks inherent in the fund going forward.  The next ten years might look very different for fixed income investors than the last ten years.

Do you have questions about your bond funds or your overall portfolio?  Please feel free to contact me.

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