The Risk of Owning a Bond Fund When Interest Rates Increase
The great advantage of owning individual bonds is they mature and you get all your money back. You become whole again. You have collected interest over the years as promised and you receive your money and can decide whether to find another bond at a different maturity and/or a better interest rate.
You are in control.
On the other hand, when you own a bond fund, you never see a maturity date. Yes, you own a diversified portfolio of bonds to minimize risk. You do receive your interest as expected, but not promised, since you do not hold the individual bond. You own shares of a Fund much like shares of a stock.
We have enjoyed low interest rates as consumers for the past ten years.
If you invested in a bond fund over the last 10 years or more, you enjoyed an increase in the share price value. We call this capital appreciation which is like a stock’s price appreciation. What has occurred for the last ten, actually 35 years, is interest rates have continually gone down. This causes bond values to go up, to appreciate.
The worm has turned!
A phrase an old broker friend of mine used to say.
The interest rate down trend is over. The Federal Reserve has been increasing the Fed Funds interest rates for the last 18 months. It raised them a little in 2016 and increased rates three times last year. And has signaled that they will continue to increase interest rates more this year.
The last thirty-five years have made people like Bill Gross large fortunes since they are long term bond investors; you can call him lucky or brilliant, it does not matter, he made the fortune.
For those who have owned Bond Funds all of these years and the lucky / brilliant ones for as long as thirty-five plus years, the party may be over. Bond fund holders may begin to lose money for years to come . . . if the losses in their bond fund principal (the underlying value of the bonds) exceed the income from interest earned on the bonds.
Bond funds have always been an important portion of an investment portfolio. It brings stability to the table and often moves inverse to stock price movement. But, when faced with a long-term decline, you may need to rethink your game plan.
If you are a bond fund holder and have enough money to invest in individual bonds, you may want to sell this position and begin building a portfolio of individual bonds. In this rate environment you should consider a laddered portfolio (see my last blog).
If you are retired and own a bond fund and you are living off the income from the interest / dividends paid out monthly, do not panic and kindly disregard this blog. Your goal is to receive income and you probably do not care if the value of the fund drops, just as long as you continue to receive your monthly income. And you most likely will.
If you are middle aged and are contributing to a 401(k) and can only invest in funds (which we are supposed to call sub accounts) and you are unable to invest in individual securities, you may want to consider exchanging your current bond fund for a short duration bond fund or perhaps even replace the bond allocation with a money market fund.
If you are younger and have a long work career ahead, you may want to do as I have referenced in the prior paragraph. Or, if you are able to handle a long continual drop in the price of the bond fund, you may wish to continue to invest in the longer-term bond funds knowing that each paycheck is a form of dollar cost averaging into your position. Ten to twenty years from now, you likely will have built a large position in a bond fund and the portfolio will have changed over time and you will own different bonds purchased yielding different (higher) interest rates. When interest rates decline, they will at some point, your bond fund holdings will rise in value.
Also, be aware!
If you currently have your bond fund interest / dividends reinvested into more shares of the investment, you will find yourself losing the value of the interest received due to the share price depreciation.
If this is the case, you may want to redirect those dividends to a money market fund, or depending on your risk tolerance, a stock mutual fund within the same family.
Target Date Funds (and sub accounts)
These investments will hurt a lot of unsuspecting investors. A target date fund is a simple fund with a defined percentage invested in bonds and a defined percentage invested in stocks. The younger you are and the longer term you have to invest, the larger the percentage of stocks you will own. As you get closer to retirement, the percentage invested in stocks decreases and the percentage invested in bonds increases.
Like a bond fund’s value dropping due to interest rates increasing, the same will occur with the bond portion within a target date fund. The performance of these funds will be dramatically affected and may make these funds downright losers over the coming years.
Target date funds have been loaded into the investment options of many 401(k) plans. With the advent of automatic plan enrollments, the investment choice is the target date fund that fits the employee’s age bracket. 401(k) plans with an automatic enrollment feature put the employee into 401(k) plans. The employee must decline in writing to opt out of the plan if they do not want to participate.
The purpose of automatic enrollments is to forcefully encourage employees to save where, if given the option up front, the employee will in many cases decline to sign up.
Target date funds may become a tremendous problem for 401(k) plan sponsors as interest rates increase. They may become a source of future lawsuits against employer plan sponsors and 401(k) plan platform vendors.
Each investor has a different set of circumstances, a different set of goals. One answer will not fit all. If you would like some assistance in reviewing your investments, we are here to help.
Contact us now for assistance.
Corey N. Callaway
Investment Advisor Representative