Six Different Ways You Could Lose Money in Bond Funds
Do You Use Bond Funds For Income? Do You Really Think They’re Safe?
Do I really want to read about losing money? YES! This article is how to potentially avoid losing money, especially if you are approaching retirement or you are already retired.
The problem is most investors think “I’m ok” or “If interest rates go up it won’t really affect me, so I’m ok”.
Well, guess what, do you even remember the #FinancialCrisis of 2008?
Bond Funds and Income Funds
What is a bond fund?
“Bond funds” and “income funds” are terms used to describe a type of investment company (mutual fund, closed-end fund or unit investment trust (UIT)) that invests primarily in bonds or other types of debt securities. Depending on its investment objectives and policies, a bond fund may concentrate its investments in a particular type of bond or debt security—such as government bonds, municipal bonds, corporate bonds, convertible bonds, mortgage-backed securities, zero-coupon bonds—or a mixture of types. The securities that bond funds hold will vary in terms of risk, return, duration, volatility and other features.*
Wait, can I even lose money in bond funds?
Yes. A common misconception among some investors is that bonds and bond funds have little or no risk. Like any investment, bond funds are subject to a number of investment risks including credit risk, interest rate risk, and prepayment risk. A bond fund’s prospectus should disclose these and any other risks. Before investing in a bond fund, you should carefully read all the fund’s available information, including its prospectus and most recent shareholder report.*
Ways You Could Lose Money in Bond Funds
#1 Credit Risk
According to the BusinessDictionary.com, the probability of loss from a debtor’s default. In banking, credit risk is a major factor in determination of interest rate on a loan: longer the term of loan, usually higher the interest rate. Also called credit exposure. AKA, the issuers of the bonds owned by a fund may default. This risk may be minimal for funds that invest in U.S. Government bonds.
#2 Interest Rate Risk
Remember the cardinal rule of bonds: When interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. Interest rate risk is the risk that changes in interest rates (in the U.S. or other world markets) may reduce (or increase) the market value of a bond you hold. Interest rate risk—also referred to as market risk—increases the longer you hold a bond.
Let’s look at the risks inherent in rising interest rates.
Say you bought a 10-year, $1,000 bond today at a coupon rate of 4 percent, and interest rates rise to 6 percent.
If you need to sell your 4 percent bond prior to maturity you must compete with newer bonds carrying higher coupon rates. These higher coupon rate bonds decrease the appetite for older bonds that pay lower interest. This decreased demand depresses the price of older bonds in the secondary market, which would translate into you receiving a lower price for your bond if you need to sell it. In fact, you may have to sell your bond for less than you paid for it. This is why interest rate risk is also referred to as market risk.
Rising interest rates also make new bonds more attractive (because they earn a higher coupon rate). This results in what’s known as opportunity risk—the risk that a better opportunity will come around that you may be unable to act upon. The longer the term of your bond, the greater the chance that a more attractive investment opportunity will become available, or that any number of other factors may occur that negatively impact your investment. This also is referred to as holding-period risk—the risk that not only a better opportunity might be missed, but that something may happen during the time you hold a bond to negatively affect your investment.
Bond fund managers face the same risks as individual bondholders. When interest rates rise—especially when they go up sharply in a short period of time—the value of the fund’s existing bonds drops, which can put a drag on overall fund performance.**
Another way to think about it is interest rate risk is the risk that the market value of the bonds owned by a fund will fluctuate as interest rates go up and down. For example, when interest rates go up, the market value of bonds owned by a fund generally will go down. Nearly all bond funds are subject to this type of risk, but funds holding bonds with longer maturities are more subject to this risk than funds holding bonds with shorter maturities. Because of this type of risk, you can lose money in a bond fund, including those that invest only in insured bonds or U.S. Government bonds.*
#3 Lack of Liquidity
Liquidity risk is the risk that you will not be easily able to find a buyer for a bond you need to sell. A sign of liquidity, or lack of it, is the general level of trading activity: A bond that is traded frequently in a given trading day is considerably more liquid than one which only shows trading activity a few times a week.**
So-called safe investments faced a lack of liquidity in 2008. It’s no secret the SEC has been and is concerned about bond and mutual fund liquidity.
Jake Zamansky writes on SeekingAlpha.com “Right now, the issue on the minds of many in the market is liquidity, or simply the ability for a seller of a stock or bond to find a buyer. Without liquidity, markets plummet, as they did in late 2008 and early 2009. Liquidity is all important to investors. It’s oxygen to markets.”
What a great comment.
I also wanted to share with you a quote by Nouriel Roubini aka Dr. Doom.
“This combination of macro liquidity and market illiquidity is a time bomb,” Roubini contends. “So far, it has led only to volatile flash crashes and sudden changes in bond yields and stock prices. But, over time, the longer that central banks create liquidity to suppress short-run volatility, the more they will feed price bubbles in equity, bond, and other asset markets. As more investors pile into overvalued, increasingly illiquid assets—such as bonds—the risk of a long-term crash increases.”
These are just 2 areas of concern when dealing with bond funds.
#4 Prepayment Risk
Prepayment risk is the risk that the issuers of the bonds owned by a fund will prepay them at a time when interest rates have declined. Because interest rates have declined, the fund may have to reinvest the proceeds in bonds with lower interest rates, which can reduce the fund’s return. (Not all bonds, however, can be prepaid.)*
#5 Reinvestment Risk
According to InvestingInBonds.com, Reinvestment Risk When interest rates are declining, investors have to reinvest their interest income and any return of principal, whether scheduled or unscheduled, at lower prevailing rates.
In a certain type of bond like a callable bond, you might not receive the bond’s original coupon rate for the entire term of the bond, and it might be difficult or impossible to find an equivalent investment paying rates as high as the original rate. This is known as reinvestment risk. Additionally, once the call date has been reached, the stream of a callable bond’s interest payments is uncertain, and any appreciation in the market value of the bond may not rise above the call price.**
#6 You CAN Lose Money in Ultra-Short Bond Funds
Ultra-short bond funds are mutual funds that generally invest in fixed income securities with extremely short maturities, or time periods in which they become due for payment. Like other bond funds, ultra-short bond funds may invest in a wide range of securities, including corporate debt, government securities, mortgage-backed securities and other asset-backed securities.
Some investors don’t realize that there are material differences between ultra-short bond funds and other investments with relatively low risks, such as money market funds and certificates of deposit. Specifically, ultra-short bond funds tend to have higher risks than money market funds and certificates of deposit (CDs).*
Understanding bond risk is extremely important because you face the risk that you might lose money.
Don’t Be Tempted to Persuade Your Clients
Recently, I've been seeing a lot of articles about Advisors persuading clients to move from active management to passive management. Persuading clients to follow the way you manage investments is a big mistake. Do this instead.
Click on image above to watch the video.
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