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This is not the time to buy bond funds

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Popular investment advice centers on building investment portfolios with a mix of stocks and bonds. But this seemingly sensible advice could be dangerous. The reason? Interest rates may be poised for a multi-year climb, a condition the world has not seen in several decades. This could lead to a steep drop in the value of bond funds. If rates rise in earnest, having the wrong kind of fixed-income exposure could prove very costly indeed.

Interest rates form clear multi-year trends. As the chart below shows, the US Treasury 10-year note fell steadily for 27 years starting in 1873, climbed for the next 20 years, went down the next 20, up the next 40, and down again the last 31. These are very long-term trends.

10-year US Treasury Note yield since 1871.

While it is possible that interest rates could settle in a directionless range for years to come, history shows that it is far more likely that they will form a new trend. The US 10-yr note yield may not go back down to the 1.52% level of 2012 for a very long time.

This is somewhat of a problem because most financial professionals today have not lived through an environment of rising rates. Rates have fallen for the last 30 years, leading investors and advisors to believe that bonds are intrinsically safe. This is not true.

When rates go down, the price of bonds goes up. That’s why the last three decades of falling rates have been exceptionally favorable for bonds. This, in turn, sparked the concept that “balanced” portfolios – i.e., those that contain a mix of stocks and bonds – are an essential feature of a solid investment strategy.

Bonds are instruments that change hands infrequently, don’t trade in exchanges, and can be mathematically complex. These are not features that an individual investor likes. As a result, a whole industry of bond funds was created to provide liquidity and simplicity to investors looking to fill the bond “bucket” and quickly became the choice for fixed-income exposure. It is relatively rare to see individual bonds (other than municipal bonds) in investors’ portfolios.

The problem is this: A bond fund is fundamentally different from a bond.

In its simplest form, a bond is a loan. The bond buyer lends money to the bond issuer; in exchange, the issuer pays periodic “coupons”, or interest payments, on the borrowed funds until the bond “face value” is repaid at maturity.

Because of this, a bond held to maturity has very little market risk. Regardless of where interest rates go, a bondholder knows with certainty how much will be paid back over the life of the bond. The individual bond represents an entirely predictable cash flow (ignoring coupon reinvestment risk, considerations about callable bonds or floating-rate bonds, and the risk of default).

Bond funds are different: they almost never hold bonds to maturity, and therefore there is no certainty as to what the cash flows will be. As time goes by, the underlying bonds get closer to expiration. The fund needs to sell shorter bonds and buy longer ones if it is to keep an average maturity constant, which in most cases is a required feature of the fund. While there are techniques that allow for some leeway in how bonds are bought or sold, in all instances the fund buys and sells bond constantly.

In an environment of falling interest rates, this is a built-in winning strategy. The fund buys a bond at a given interest rate and sells it several months later at a lower one. Because the price of a bond goes up when rates go down, the fund is always buying low and selling high – the bedrock of successful investing.

This has been a blessing for bond fund managers over the last 30+ years as interest rates declined steadily since the early 1980s. This exceptionally favorable environment allowed for “star” managers to pop up, like Bill Gross of PIMCO (the “bond king”).

But the opposite scenario – increasing rates – is the bond fund manager’s worst nightmare. To keep average maturity constant, the fund must sell bonds at a higher rate than the one at which it bought them earlier. In other words, the fund is forced to buy high and sell low. There is very little a bond manager can do to mitigate this risk.

The only positive aspect is that as interest rates rise, so do the “coupons” that the new bonds pay out to the fund. When rates are high enough, large coupons can offset the loss of price caused by higher rates. But when rates start climbing from very low levels, like now, the coupons are too small to offset the price loss.

Putnam Income Fund Class A, 1969-1980.

This is exactly how it has worked in the past. The graph above shows the net asset value (NAV) of one of the oldest bond funds around – the Putnam Income fund (PINCX) – during the eleven-year period from 1969 through 1980. In those years the 10-year US Treasury note yield rose from a little over 5% to almost 13%, wiping out more than 40% of the fund’s NAV. While some of this loss was offset by coupon payments averaging 8%-10%, such cushion does not exist today because coupons are far smaller. Investors in similar bond funds could see large NAV losses with little offsetting income.

What to do? The Federal Reserve is expected to raise rates this year, which in the past has almost always been followed by a succession of further hikes. If and when market participants suddenly become convinced that a new upward trend in rates has started, they may want to sell their bond funds at the same time. This flood of supply can create a steep drop in the price of bonds, especially because bond liquidity has suffered because of financial reform. Clearly, bond funds are not the place to be if interest rates start to rise in earnest.

The moral is this: In this environment, investors who want to carve a portion of their portfolios for safety may be better off with cash. Those who already own individual bonds may want to commit to hold them until maturity. But bond funds have become very vulnerable to a rise in rates, and it will be a while until they are high enough so that large coupons can offset the damaging effect of rising rates. This is not the time to buy them or hold them.

What now?

Our clients want to make sure that their investments are managed efficiently and prudently, and that they partner with an advisor who helps them cut through the market noise. We look at their specific situations and use quantitative techniques and solid execution expertise to build and maintain investment portfolios that are suitable for their needs. We try to identify when to buy or sell different asset classes, with a focus on controlling downside, seeing through the haze of short-term volatility, and looking at what securities are priced favorably at various times. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more