Bond Mutual Funds: What You Need to Know
Conversely, stock mutual funds, excluding emerging markets, were only around $30 billion. Over longer periods of time, stock mutual funds garner a significantly larger share of mutual fund inflows than do bond funds. However, considering investor disappointment with the stock market in 2008 and early 2009, as well as overall investor anxiety, it’s not surprising to see investors seek the perceived relative safety of bond funds.
Unfortunately, bond funds are not necessarily safe, and the record inflow into bond funds suggests the possibility of investor disappointment as we move forward. To the point of potential investor disappointment, recall that in late 1999 as the tech bubble was heading toward its peak, investors were placing incredible sums of money into stock mutual funds that focused on technology stocks.
By the end of the first quarter 2000, the NASDAQ had peaked in price and over the next two years declined 75 percent.
More recently, during the housing and commodity bubble, investors had a strong bias toward home building and commodity stocks only to watch their prices crater. Thus, investors are possibly on the verge of making the same mistake with bond mutual funds. To be sure, bond funds certainly do not have to go down in price; however, history suggests that many investors tend to be ill-timed with their investment decisions. Whether bonds are positioned to go down in price or not, it’s prudent to make ourselves aware of the potential risks.
According to the Investment Company Institute, which is a national association of U.S. investment companies that includes mutual funds and whose members manage total assets in excess of $12 trillion for over 90 million shareholders, some of the inherent risks of bond mutual funds are as follows:
Interest rate risk
Bond prices are closely related to interest rates. When interest rates go up, most bond prices go down. When interest rates go down, bond prices go up.
The longer a bond’s maturity, the more its price tends to fluctuate as market interest rates change. For example, a rise in interest rates will cause a larger drop in price for a 20-year bond than for an otherwise equivalent 10-year bond. However, while longer term bonds tend to fluctuate in value more than shorter term bonds, they also tend to have higher yields to compensate for this risk.
A bond mutual fund does not have a fixed maturity. It does, however, have an average portfolio maturity—the average of all the bonds’ maturity dates in the fund’s portfolio.
In general, the longer a fund’s average portfolio maturity, the more sensitive the fund’s share price will be to changes in interest rates and the more the fund’s shares will fluctuate in value.
With respect to interest rate risk, using U.S. government bonds as an example, is it possible or even likely that interest rates in the United States ultimately move higher due to the magnitude of U.S. government debt? In other words, will investors ultimately demand higher interest rates? Will the Federal Reserve deliberately raise rates as the economy improves?
Any force that causes interest rates to move higher will be a negative for the prices of bonds.
Credit risk refers to the creditworthiness of the bond issuer and its expected ability to pay interest and to repay its debt. If a bond issuer is unable to repay principal or interest on time, the bond is said to be in default. A decline in an issuer’s credit rating, or creditworthiness, can cause bond mutual fund share prices to decline.
If the economy softens, will investors start to question the creditworthiness of the bond’s issuer? Will the current creditworthiness concerns about sovereign debt of Portugal, Greece and Italy spread?
Again, any force that causes a concern about the creditworthiness of an issuer will be a negative for bond prices.
Choosing an investment solely for its stability entails inflation risk. Inflation erodes the purchasing power of any investment. For example, suppose $1,000 in a deposit account earns 5 percent interest, but inflation is 2 percent per year.
Although this money will earn $50 in interest after one year, inflation cuts the actual worth of this $50 down to $49. In addition, the initial $1,000 will also erode by 2 percent to $980.
Therefore, after one year, the deposit account has a balance of $1,050, but due to inflation, it is only worth $1,029. This is the effect of inflation risk.
To maintain an investment’s value, its total return must keep pace with the inflation rate.
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Doug Adler AAMS®, WMS is senior vice president, investments and registered principal of Raymond James & Associates. Adler specializes in risk managed portfolio strategies and retirement planning to assist families in accomplishing their investing and personal goals.