Although usually considered safer than stocks, bonds carry their own risks. In particular, bond funds present specific risks not found in individual bond investments.
Bonds have long been viewed as a port in the storm, a low-risk asset class that creates consistent cash flow and helps to balance equity market mood swings.
But Shelly Schwartz of CNBC wrote about the “top six ways the most benign securities in your asset mix can potentially pack a punch”.
1. Interest-rate risk …
2. Bond fund risk …
3. Credit risk …
4. Liquidity risk …
5. Inflation risk …
6. Reinvestment risk …
Each item is detailed in the CNBC article. I have a particular aversion to bond fund risk, and strongly prefer individual bonds or Unit Investment Trusts over bond funds in my own portfolio. I invest in bonds for longer-term stability and consistent yield, two features often missing in bond funds.
Bond fund risk
Unbeknownst to many, bond funds also expose investors to a unique set of risks in a rising rate environment that individual bonds do not. Why?
Individual bonds, like Treasuries, municipals and corporate bonds, are sold with a finite maturity: the date on which you, the investor, get your principal back—if the debt issuer doesn’t default—and the interest payments you’ve been receiving stop.
Interest-rate fluctuations don’t affect investors who hold individual bonds to maturity.
Fixed-income securities held within a bond fund, however, are designed to mature on a staggered basis, creating a perpetual income stream for investors. The fund manager replaces bonds as they mature, when the issuer’s credit is downgraded and when the issuer “calls,” or pays off the bond before the maturity date.
When bond prices fall as interest rates rise, the net asset value (NAV) and return of a bond fund also decline, said Greg Ghodsi, senior vice president of investments at Raymond James.
A $300,000 investment in a fixed-income mutual fund with an average maturity of 20 years (a mix of 10-, 20- and 30-year bonds), for example, would be worth $260,000 if interest rates climb just 1 percent. (Shorter-term bond funds would be less volatile.)
But the pain doesn’t end there. The drop in value makes investors nervous, which prompts more selling. That forces the fund manager to unload some of their holdings to meet redemptions, said Ghodsi.
Depending on how significant the redemptions are, he noted, they may have to sell their highest-yielding bonds and replace them with those offering a lower yield, or assume more risk to obtain the same return, which can drive prices quickly lower.
The investors who didn’t bail get stuck with an investment that may not match their risk profile or income needs—one that is suddenly a lot less liquid on the secondary market. Ouch.