Bond Funds-Putting Your Retirement at Risk

Over the last 2 decades, it has not mattered whether you owned U.S. bond mutual funds or a portfolio of individual bonds. Interest rates were going down and stayed down. So both bond mutual funds & individual bonds delivered consistent income, some growth, and a counterbalance to stock market volatility.

Last December the Federal Reserve raised interest rates by .25%, and it is likely the Fed will do so again this December. Safe to say with interest rates near zero, higher interest rates are on the horizon. If you agree this is the likely scenario, investors are going to quickly see the difference in these two approaches to owning bonds (owning bonds inside a mutual fund versus owning a portfolio of individual bonds).

Individual bonds are sold with a stated date when they will mature, this is the date on which you, the investor, get your initial investment back and the interest income you've been receiving stop. If you own individual bonds with a fixed rate of return (yield) and hold them to maturity, interest-rate fluctuations from the Federal Reserve impact neither your principal nor your income stream.

The only time interest rate risk becomes a factor, is if you sold your individual bonds before maturity. Depending on the price you paid for the bonds, the amount of interest you've already collected, and current interest rates, it could result in either a profit or a loss. But again, if you hold them to maturity, assuming no defaults, you’ll get your original investment back.

Bond Mutual Funds are Different.

Bond mutual funds are different. Bonds held within the mutual fund portfolio are designed to mature on a staggered basis so that income payments are delivered consistently. Bond mutual fund investors can expect a monthly payout of the income earned by the mutual fund.

However, because you own mutual-fund shares, there is no maturity date on which you can expect to get back your original investment.

Many investors mistakenly believe the diversification built into a bond mutual fund makes them more insulated from market forces. That is not necessarily the case.

With bond mutual funds, rising interest rates can create a snowball effect that drives prices quickly lower. Let me explain.

Selloffs, supply and price.

A $300,000 investment in a bond mutual fund with an average maturity of 20 years (a mix of 10, 20 and 30 year bonds), could fall to $260,000 if interest rates climb 1%.

Why does this happen you ask? If interest rates go up, then why would a potential investor want your bonds when he can buy new bonds with a higher interest rate? In order to sell your bonds, you would have to lower the price of your bond to the point that the yield now equals that which a new bond is issued.

The drop in value seen on monthly statements makes investors nervous, which prompts more selling. That, in turn, forces the bond-fund manager to sell off some of the bonds in the fund to meet redemptions, flooding the market with bonds, which increases supply which, then, in turn drops prices lower still.

It's a downward spiral. It takes very little shift in the supply and demand to cause prices to shift dramatically.

With all the redemptions and selling, the mutual fund might now be forced to cut their dividend, so your actual monthly income goes down. You get squeezed from both ends. Not only does the statement show a lower value, but now your income gets cut too.

By comparison, if you own $300,000 worth of fixed-rate individual bonds with an average maturity of 20 years and interest rates go up 1% percent, the value of those bonds on your statement might be down, but your income remains unchanged. You are unaffected by what other investors do. And more importantly, you'll still get your principal back when the bonds mature—assuming, again, that you buy and hold the bonds, and the company doesn't default or the bonds are not called.

Also, with an individual portfolio of bonds, a smart manager will have the ability to take advantage of the oversupply, buying bonds at a discount, holding them to maturity and you reap the benefits.

FYI.

The default rate on investment grade bonds over the last 5 years is right around 1%, which means for every 100 bonds issued only 1 bond will default. A default is when the bond issuing company stops paying interest or does not re-pay the principal back at maturity. And an investment grade bond is rated BBB- or higher by Standard & Poors, they are bonds that have a relatively low risk of default.

Many investors own bond mutual funds inside of their investment, retirement, and 401k accounts. Give us a call and let us review your portfolio to determine if you are at risk. Make the changes now to mitigate some of the risk from rising interest rates.

Securities and investment advisory services are offered through Next Financial Group, Inc., member FINRA/SIPC. None of the names entities herein are affiliated.