Reconsidering The Role Of Bond Funds
Bonds are an important part of a well diversified investment portfolio. They are widely viewed as a safe, low risk component for investment allocations, with an aim of preserving capital and generating income. Bonds function like loans. Investors provide money for a period of time to finance projects. When the bond matures, the principal is returned, and interest is paid along the way. There are a number of ways to incorporate this asset class in a portfolio including directly investing in individual bonds or purchasing various types of bond funds. While the intent of both of these is the same, they present significantly different risks.
Individual Bonds vs. Bond Funds
The primary difference between owning an individual bond and investing in a bond fund is that individual bonds mature, while bond funds are perpetual. Bond funds have no maturity or end date. When an investor decides to sell their position in a bond fund, they are subject to market valuation. This variable value reduces the certainty of future cash flow and diminishes one of the primary purposes bonds are held. Additionally, bond funds subject investors to the behavior of their fellow shareholders. So, when investors sell a bond fund, the manager must sell off holdings to fund distributions or hold cash in anticipation of distributions.
The Impact of Rising Interest Rate
Because higher yields are available to investors as market interest rates rise, bonds, which have fixed interest rates, decline in value. During the second quarter of 2015, as interest rates rose, bond funds posted their first meaningful loss in quite some time. In addition, bond funds, normally considered stable investments, have experienced significantly higher volatility. According to Morningstar Inc., long-term government and corporate bond funds have been more volatile, relative to equity funds, than at any time in the past 15 years. The situation is compounded by growing press about the perils of bond funds and expectations that the Federal Reserve will increase rates soon. After steadily piling money into bond funds for the past several years, the flow is shifting as investors have begun to reduce their exposure to bond funds.
What To Do
Holding individual bonds in your portfolio is one way to avoid the risks inherent in bond funds. By building a portfolio of high quality bonds and holding them to maturity, an investor can, providing there are no defaults, lock in a known rate of return with regular cash flow. This approach is not feasible for some investors, as the market for individual bonds typically requires at least $100,000 be invested in a portfolio of individual bonds to build a diversified portfolio.
A relatively new alternative, defined maturity bond funds, tries to bridge the gap. These funds have defined maturity dates like individual bonds. This feature allows investors to build a portfolio with established returns and the cash flow they desire, much like individual bonds. The drawback with defined maturity funds is that there are expenses and managers need to keep cash available for redemptions, so the yield is watered down by these costs.
Having identified some of the pitfalls, most portfolios will still hold some, if even a small portion of the allocation, in traditional bond funds. They do present an easy way to get exposure to bonds and can be converted into cash readily. Investors concerned about the risks of bond funds would be well served to keep average maturity short, costs low and avoid the urge to reach for yield using speculative investments. As always, a conversation with an investment professional is a beneficial way to assess the risks and available alternatives for investors seeking stable income production.