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Bond Funds: The Reality

February 24, 2012

Conventional wisdom is that bond mutual funds are a safe way to invest for fixed income.  Many advertisements right now laud the high “total returns” of individual funds during the last few years.

 

QUESTION: If bond funds are so safe then what are the circumstances that cause their returns to be much greater than the coupons on the individual bonds in the fund?  And if circumstances can provide huge returns, can’t they change and provide huge losses at a later time?

 

THE REALITY: Bond values fluctuate as market determined yields change. When market interest yields rise, bond values decline; when yields drop, values increase.

 

Bond funds’ quotes of  “total return” is a combination of the actual interest paid plus or minus the change in value due to fluctuating market yield rates. If the bond fund pays 3% interest and the value increase is 4%, then the total return is given as 7%. With 3% coupons, if market yields increase, and the fund’s value drops 4%, the total return will be a negative 1%! In both situations, the investor neither receives nor pays the total return —they only receive the coupon interest.  The market change causing the plus or minus return results from the funds’ increased or decreased values.

 

If you own individual bonds that are intended to be held to maturity, the changing values won’t mean too much to you.  At maturity you will get the face amount paid to you.  However, with a bond fund, the truth is that that there is never a time when you can get back what you invested in the fund – you can only get what the market says the value of the fund is when you are ready to cash out. And if that comes at a time when market yields have increased, you can look forward to losses from your “safe” investment.

 

Given today’s extremely low rates, it is probable that yields will increase within the next few years. If that occurs, bond fund investors can look forward to huge drops in the market value of the conventional wisdom “safe” investment. Consider this when considering fixed income investments.

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