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Bond Investing – There Will Be Blood

The latest rage in investing has been a movement from equity mutual funds to bond mutual funds as a way to protect assets in a turbulent market.  This has been a good strategy in 2010 as bond mutual funds have generally out-performed equity funds.  While I am a conservative investor and generally like bonds, bond mutual funds and investing in longer-term bonds should not be viewed as a totally safe alternative to equity mutual funds. 

Bonds trade on several factors: risk of the underlying issuer, current interest rates, demand for bonds overall, and perception of risks and where interest rates are going to be in the future.  A change in any of these will cause the bond value to move. The longer a bond has to maturity the more volatile the valuation of the bond or bond fund.  That is the case as bond mutual funds have to re-value their entire portfolios to current market values on a daily basis. 

Let’s take a look at how just a small movement in interest rates impacts the value of a bond.  Let’s assume that we have one 10 year bond with a face value of $100,000 with interest payments set at 2.5% with interest paid every 6 months.  This is similar to where 10 year Treasury notes have been recently trading.  You might think you have a nice safe investment but a 1% increase in interest rates reduces the market value of that $100,000 bond by over $8,000 resulting in an 8% loss.  A bond fund must reflect this loss and if you own shares in that fund so you just got “dinged”.  Clearly the opposite could happen and interest rates go down and the value of the bond goes up which is what has happened over the past year. Remember bond values go up when rates go down and vice versa so owning a bond is a bet on lower interest rates in the future.

But let’s be realistic.  Short-term rates are near zero and 10 year Treasuries are trading at the lowest yield in decades so do you really think there is a lot of room for rates to fall further? 

An option to investing in bond funds or longer term individual bonds is the so-called “step-rate” CDs and notes issued by government agencies. These are generally safe from a credit standpoint and they re-set interest rates upward over time giving you some protection against sharp increases in rates. They also yield considerably higher returns than a money market fund or bank deposit.  They are not as liquid as cash in the bank or a money market but may prove to be the better investment compared to a long-term bond fund.

 Consult your investment and tax advisors and ask them about your exposure to long-dated bonds and if step rate instruments might not be a better fit for you.

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