Bond Funds May Not Be as Risk-Free As You Think

by Kevin Mercadante

With the stock market largely stalled since May – albeit in record territory – nervousness is developing by investors wondering which direction it will go in from here. That kind of doubt breeds a natural inclination to seek out investment alternatives. One such alternative, traditionally, has been bonds. But since so few people fully understand investing in bonds directly, bond funds are often the vehicle of choice. But bond funds may not be as risk-free as you think.

The Inherent Risks of Holding Bonds

bond funds are not risk-free

Bond funds are not risk-free.

While we often think of bond as “safe,” they have two inherent risks: default and interest rate risk.

Default is easy enough to understand. If the bond is issued by a corporation or even a local government agency, there’s always the possibility that the issuer may hit on financial difficulties and default on either the interest, the principal, or both.

But you can generally get around this by staying in funds that invest only in the US government securities, which are immune to default since the US government can literally create the money to pay them off.

Interest rate risk is a more complicated one, and the virtual Achilles’ heel of bonds. Simply put, bond prices move in the opposite direction of interest rates. When interest rates fall, bond prices rise – much like stock prices. But when interest rates rise, bond prices fall in order to keep their rates competitive with current levels. This is also true of US government securities, but particularly those with 10 years or more to maturity.

Of course, the way to minimize this risk is by investing in shorter-term securities. For example, 30 year bonds that have 25 years remaining on them, are highly sensitive to changes in interest rates. But a 10 year bond – with three years remaining – will be only minimally sensitive to rate changes, since the ultimate payoff is so close.

If you are looking to invest in bond funds in order to offset the risk of stocks, you want to stay with funds primarily invested in US government securities with maturities less than 10 years. This will eliminate the risk of default, and minimize interest rate risk.

Fund Portfolio Composition

There is another X factor when investing in bond funds, and that is the actual fund portfolio composition. The bond funds – in an effort to improve fund yield – will invest in a mix of bonds. That can include US government securities, state and local government bonds, corporate bonds, “junk bonds,” and even foreign bonds.

While this may achieve the funds desired goal of increasing yield, it will increase the risk of loss of principal. Other than US government securities, any of the bonds held in the fund could be defaulted on.

One other area to pay particular attention to concerning government bond funds. While a fund can be comprised entirely of government bonds, they may include foreign government bonds. After all – they are government bonds, technically speaking. Among their holdings of US government securities, they may also include higher-yielding instruments from non-US sources that will introduce the risk of fluctuating currency values.

I think it’s safe to say that when investing in bond funds, most people are looking for preservation of capital. As you can see however, not all bond funds necessarily deliver on this expectation.

Your best protection is to get a copy of the fund’s prospectus before investing any money. Find out specifically what their investment holdings are – and makes sure they match your investment goals. Also pay close attention to their historic performance. Significant declines in investment value over the past 10 years can be an indication that it’s not the fund for you, especially since interest rates have behaved so reliably over that time period.

Stocks and Bonds Aren’t so Mutually Exclusive

The key to solid portfolio management is maintaining a mix of mutually exclusive investments. But if you are looking for diversification away from stocks, bonds – especially long-term bonds – may not be so mutually exclusive.

Historically, both stocks and bonds have risen in price on lower interest rates. They’ve also tended to decline in tandem during periods of rising interest rates. While bonds react to changes in interest rates on a mechanical basis – because it intimately affects yield – stocks react because changes in interest rates affect corporate borrowing, and the general direction of the economy. The similar reaction to interest rate changes puts both stocks and bonds too close to achieve true diversification.

The Safer Alternatives

If you’re looking for safety of principal as a diversification away from stocks, short-term US government bond funds will be the preferred alternative. But perhaps even better is holding short-term US government securities direct. You can do this through the US Treasury’s investment portal Treasury Direct, where you can buy any type of Treasury securities in any denomination and for any term you choose.

You can also buy Treasury securities through your bank or brokerage firm, although there will be a nominal cost to do so. Alternatively, you can also invest in certificates of deposit or even money market funds. Each will provide safety of principal, along with regular interest income, and represent a complete diversification away from the risks of a portfolio invested 100% in stocks.

Have you ever invested money in a bond fund only to find out that it was not quite as safe as you expected?

Published or updated November 15, 2013.
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