Avoid the Bond Fund Trap

March 30, 2010 by  
Filed under Investing

Investment professionals often preach to the masses (that’s us) that two of the biggest killers of investment returns are fear and greed. (That would be our fear and greed. Investment professional tend to overlook the impact of their own greed.) I’m familiar with these very human frailties. I’ve struggled with my own fear of loss as in impediment to making rational and timely financial decisions. 

I think I’ve mostly overcome my own investing fears. As one example, I was able stay invested in the market when the market tanked in 2008 and early 2009.

In my book, making investment decisions based on fear and engaging in risk-adjusted behaviors are distinct concepts. A fearful investor may tend toward doing nothing, even in the face of overwhelming evidence that something should be done. An investor that modifies his or her investing behavior based on risk tolerance is more likely to make rational decisions. In our case, I adjusted our equity allocation downward during the market decline, putting new money into cash-equivalents. I also sold some high risk financial stocks before the bottom completely fell out. This made sense for us because of our age.

This brings me to the ultimate topic of this post: avoiding the bond fund trap.

It seems that fear is still guiding the investment behavior for lots of us. My basis for this statement: In the past year, investors have funneled $506 billion into mutual funds. You might be wondering how that manifests fearful investing. The answer lies here: Of the $506 billion invested in mutual funds, $409 billion was put into bond funds. (That’s 80% in bond funds for the tired brains out there.)  (Source)

This brings me to the “trap” part of my warning. The average investor sees the word “bond” and immediately thinks “safety” compared to stocks. Heck, “bond” just sounds more secure. That’s my theory of why bond funds are so popular now compared to equity funds. The fearful investors put their money in bond funds, believing that bond funds are “safer.” But that’s not necessarily true.

Granted, a highly rated bond is clearly “safer” than a stock in that you are less likely to lose your investment. The caveat is that you must hold the bond until maturity.

Many casual investors assume that because bond funds own thousands of individual bonds, the funds are also “safe.” This is a false assumption. First, bond funds rarely hold bonds until maturity or if they do, the bonds mature at different times. This means that the market value of the fund shares is subject to fluctuations in the market (trade) value of the underlying bonds. The bond market values are subject to interest rate risk, among other factors. If interest rates rise after an investor buys shares in a bond fund, the share value is highly likely to decline in proportion to the increase in interest rates. This is because the market values of the bonds owned by the fund are falling with increases in interest rates. (An exception may be a bond fund that holds only bonds with a short duration until maturity.)

In summary, a belief that bond funds are “safe and secure” is a trap for the fearful investor. In some circumstances, such as an economy experiencing interest rate volatility, bond funds can be riskier than equity funds.

So avoid the bond fund trap. Do not let fear control your investing behavior. Look beyond your fear (and your greed) when making financial decisions. If you are incapable of controlling your emotions when planning your financial future, get some help. You will be glad you did.

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9 Responses to “Avoid the Bond Fund Trap”
  1. Snowy Heron says:

    So how do you put together a 401k portfolio when you are close to 60 and don’t want everything in stocks? There aren’t a lot of options: money market fund, bond fund or stock fund. It is more a case of choose your poison!

  2. kitty says:

    Snowy Heron – what about stable value? I am 50 and I have a large chunk of my 401K there.

    I might be too conservative in 401K, but I have a larger portion of my taxable money in stocks where I can get taxed at 15% on long term capital gains and get to deduct the losses – something I cannot do in 401K. Plus I figured, if I’ll have enough for retirement with less aggressive strategy, why take more risk than I need to? At least I can sleep at night about my 401K.

    I have a few individual bonds too in my taxable accounts – municipal and corporate, and some I bonds. Not enough bonds for diversification – bought corporate/muni at the height of credit crisis to get good yields, but now interest rates just seem too low.

    Main thing though — pay attention to interest rates. It doesn’t look right now that they’ll go up really soon, but they will at some point. If the economy starts to pick up and it looks like the government will raise rates, it might be time to pull out of bond funds.

    This is what I do, and as I don’t have any particular expertise, I may be totally wrong.

  3. MasterPo says:

    Without getting into very complex investments, short answer: You can’t.

    You need some equity exposure.

    It’s just a matter of how much you can handle risk wise.

  4. avery says:

    So when rates rise, the bond fund value declines, but my question is – don’t yields in the fund then increase because of the rate increase, to some extent offsetting the loss?

    We are pretty heavily tilted to stock index funds, and rode out the crisis without making any changes; however, the experience taught me that I do want to rebalance to a greater allocation in bond index funds. The crisis and since have given me a look at ‘political risk.’ This experience made me realize my risk tolerance is not so very high after all.

    But I haven’t changed anything yet.

  5. MasterPo says:

    “Rate” and “yield” are two different things.

    The rate of a bond is the fixed (in most cases) interest amount it pays while the yield of a bond takes into account the market value of the bond.

    So if you have a 5% and interest rates go down that bond is worth a lot more than just 5%. That is because to get 5% when rates are otherwise lower you have to pay more which offsets the value of the intrest income stream. The value of the bond goes up so the yield goes down because now you have a bit of capital appreciation with it.

    By contrast, if rates go up 5% is worth less so the value of the bond goes down. Therefore the yield of a 5% is higher because you’re getting 5% at a lower price.

    Therefore to answer your question more precisely, when rates drop the value of higher interest bonds goes up and there for the yield goes down. And similarly when rates go up the value of the bonds goes down and the yield goes up.

    Some bond funds list the average coupon rate of their holdings. Many don’t though.

  6. kitty says:

    Avery – in addition to what Master Po said. If you are in a bond fund, the individual bonds in the fund have different coupon rate and different maturity. So while the value of current bonds in the fund goes down when the interest rates go up, the new bonds that a fund buys get new higher rate. So eventually, this higher rate on new bonds may compensate for the loss in value, but it’ll take time. Sometimes manager doesn’t wait to maturity, and sells at a loss. A bond fund with shorter duration bonds is less volatile.

    Now if you have individual bonds, you can ignore the fluctuation and wait to maturity. But you need a certain amount of money to buy enough individual bonds as the are sold in lots of 5 of $1000 in face value each lot, so the minimum investment is around $5000. I say around because it is $5000 in face value of bonds, but you pay less if the bond is selling at a discount (i.e. below its face value) and more if it is selling at a premium. So if you want to be diversified, you need to have money to buy many issues. Then, you will not get compounding unless you have enough money in bonds that the bond’s interest paid twice a year is enough for another bond issue.

    @MasterPo – regarding exposure to equity. It’s really all depends on how much return one needs. If one already has enough money for retirement or one’s situation is such that he can save enough without risk, than why take any risk? There is no need to risk more money than necesary to achieve one’s goals.

  7. MasterPo says:

    Kitty –

    1) Most bond funds rarely hold bonds – even short term bonds – to maturity. Not sure who gets stuck with it at maturity but usually not the fund.

    2) What is “enough”? There is no answer. Trying to predict how much you will need for a 10-20-even 30 year retirement period is reading tea leaves at best. Toss in 2-3 years of high inflation (do you REALLY believe there was no inflation in 2009? And won’t be any in 2010 either?!) and your money reserves just crashed and burned.

    Without getting another job equities are the only way to try (no promises) to compensate for the unknown.

  8. Bret says:

    “Shaken, not stirred” – James Bond

    The time to get into bond funds was about three years ago, when greed was in full control of the stock market. To do so now, with interest rates at close to zero and soon to rise, would be a huge mistake. Even Bill Gross (The head of PIMCO) is saying whoa.

  9. Question: Where does everyone come up with the idea that bond funds do not hold most bonds to maturity? This is something that is repeated over tme and people just accept it. They do some trading but they hold a lot to maturity.
    Is everyone sure rates are going higher? Then short the market. An easy way would be to buy TBT. I’d be careful though – it is very risky. The point is that if you are so sure rates are gong higher there is a way to play it.
    A more conservative way would be to buy a ETF comprised of adjustable rate bonds.

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