Because, if you don’t, you could be a step away from having 25% of your bond money wiped out.
Recently, more individual investors have been piling into bond funds to escape the volatility of stocks. On the surface, bond investing looks easy -- pick a fund with a good track record and high credit rating, and off you go.
I’m here to tell you that nothing could be further from the truth, because unless you own the right type of bond fund you could be putting 25% or more of your entire bond portfolio at risk of permanent loss.
Let me explain...
The Super Cycle
From 1962 to 1982, bonds had been in a 20 year bear market. Then in 1982 bonds reversed and started on a massive bull market. After 30 wonderful years, it finally looks like the bull market in bonds is about to finally reverse course (for the reasons why click here).
When interest rates go up, bond prices fall, causing the market price of these “safe” investments to decline. How a bond responds to changes in interest rates is described by the investment term duration. This is really important so bear with me: Duration measures the change in value of a bond per one percentage point change in interest rates.
For example, if a bond or a bond fund has a duration of five, that implies that if interest rates rise by 1% then the value of the bond or bond fund will fall by approximately 5%. The higher the duration, the greater the impact on the value of a bond or a bond fund.
Got it? Good! Let's move on...
Duration is influenced by a bond’s coupon (interest) payment and its time to maturity. Bonds with low coupon payments and long times to maturity are impacted the most by changes in interest rates. High coupon bonds with short maturities are the least sensitive to changes in interest rates. Unfortunately, in today’s environment there are not many bonds that offer high coupons with short maturities.
If you own an individual bond at its issuing price (also known as par value) and interest rates rise, the market price of that bond will fall. However, although you’ll be missing out on some opportunity, you can hold the bond until maturity, at which point you will receive 100% of your principal back.
Now here’s the key, and the reason why most bond funds are ticking time bombs:
A bond fund has a perpetual duration, and that means that in a rising interest rate environment, bond funds can decline in value for a very long time with near ZERO hope of recovery of your initial investment. This is because you cannot hold a bond fund to maturity the way you can with an individual bond.
One of the most popular bond funds, offered in many retirement accounts, is the Vanguard Total Bond Market Index (VBMFX). It has an effective duration of just over 5. So if interest rates increase by just 1%, the value of this fund will decline by roughly 5%.
Now that may not seem like a big deal, but consider this: The 50 year average yield for the 10 year T-note is around 6.7%, compared to current rates of around 2%. So once the bond bear market begins in earnest, you can see how it will ravage the value of this fund.
When the world’s central banks quit propping up the bond market through quantitative easing, rates will rise. At the very minimum they will return to the 6% range, and that is going to cause a lot of investors in “safe, conservative” bonds to suffer.
The bottom line is that you need to check the duration of any bond funds you have. This information is readily available on the fund company’s web site. Many popular funds have durations in excess of 10, meaning that for a 1% increase in interest rates, that fund can fall by as much as 10%.
If you plan on holding high duration bond funds for a number of years, then you are planning to lose money.
This may be the only opportunity you get to shorten the duration of your bond funds. In fact, in many cases you might be better off simply getting out of the fund altogether and purchasing your own short duration bonds. Although you may be sacrificing opportunity, you will get your full principal back rather than seeing it deteriorate year after year in a rising rate environment.
Price Shock Trader