Investors poured billions into bond funds in 2009. Through the end of November, Morningstar reports that $262 billion had flowed into taxable bond funds and another $67 billion into municipal bond funds, while flows for stock funds, even including popular international stock funds, barely broke even. The almost nonexistent returns on money market funds since the market meltdown one year ago are a primary factor driving investors into bond funds.
After the brutal beating stocks took in 2008, the public is understandably gun-shy and looking for ways to avoid risk. And bond funds are less risky than stock funds, right? Maybe.
Individual bonds owned by an investor generate more predictable, albeit lower, returns than stocks. However, a pooled investment such as a mutual fund that holds bonds can be surprisingly risky. Here’s why.
At the heart of any bond are promises to pay interest and repay principal, which typically are fixed at the time a bond is issued. At any given price, the return on any bond from the date of purchase to the date of redemption can be calculated with mathematical certainty. It’s also possible to calculate something called the “duration” of a bond that measures how sensitive its price is to changes in prevailing interest rates.
Many investors have heard the old saw (pun intended) that bonds act like a seesaw: As interest rates rise, bond prices go down, and vice-versa. Duration lets us predict the degree to which the seesaw will move.
Suppose you purchase a newly issued U.S. Treasury bond at “par” (100 percent of its redemption value) that pays 4 percent interest and will repay the face amount of $10,000 in 10 years. If prevailing interest rates rise from 4 to 6 percent in a few months when the Treasury next issues similar bonds, what will happen to the market value of the bond you just purchased?
Using a calculator readily available on the Web (try www.investopedia.com), the duration of a 10-year bond paying 4 percent interest purchased at par is found to be 8.34. When we multiply the duration by the change in rates in percentage points, we get a good estimate of the decline in value of our bond if interest rates rise: in this case, about 16.7 percent (two times 8.34). The bond we paid $10,000 for a few weeks ago will now fetch only about $8,340, if we wish to sell it. Keep in mind that if we hold the bond to maturity, we can disregard the present decline in market value with the knowledge that by the time of maturity, its value will work its way back to par, assuming the issuer’s credit is good.
A portfolio of bonds held by a mutual fund can be measured for its duration in the aggregate. Mutual funds must mark the value of their holdings daily to determine a net asset value (“NAV”) at which investors can buy or sell shares. And holding bonds to maturity is the exception rather than the rule for bond fund managers, so changes in NAV will have more of an impact for owners of bond funds than for holders of individual bonds.
In the table here, I’ve listed three Vanguard bond index funds that have generally the same credit quality characteristics and that vary primarily by their durations. The returns for each fund over the past year have been impressive, ranging from 7+ percent for the short-term to more than 17 percent for the long-term fund.
Fund Symbol Past Year Return Duration SEC Yield Projected Return
Short VBISX 7.31 2.6 years 1.34 percent -3.86 percent
Interm VBIIX 15.61 6.4 years 3.69 percent -9.11 percent
Long VBLTX 17.34 12.3 years 5.09 percent -19.51 percent
The “Projected Return” in the table is the likely result if interest rates rise by 2 percent from their present levels during the coming year, combining the funds’ yields and changes in NAV. Looking only at past returns, one would be tempted to go with the long duration fund. But looking forward, the risk there is much greater.
Of course, the $64 question is, what will interest rates do over any given period in the future?
Never in my adult life have prevailing interest rates been anywhere near as low as they were in 2009. Between 1969 and 1998, 10-year Treasury bonds never yielded less than 5 percent, and until the end of 2007, only briefly yielded less than 4 percent. Throughout 2009, 10-year Treasuries yielded mostly between 3 and 4 percent.
What’s currently keeping bond yields low is the same thing driving investors out of money market and bank savings accounts: the Federal Reserve’s current zero interest monetary policy. Flows from cash into bonds generated by that policy have driven bond prices up, with the consequent seesaw effect of driving yields down.
Once the economy begins to recover, the Fed will have to take its foot off the economic accelerator that’s now pressed all the way to the floor. Short-term interest rates will go up, as banks and money market funds must again begin to compete for investors’ savings. And funds will begin to flow out of bond funds into other investments, reinforcing the rise in yields and consequent declines in bond prices.
Investors who chose a bond fund based on recent returns are driving by looking into their rear-view mirrors. If your purpose is to preserve principal, a 20 percent loss over one year would be very painful. An increase of 2 percent in prevailing interest rates over the next year is more likely than a 1 percent decline. Avoid the potential for major losses to your defensive holdings: Keep the duration short for any bond funds you own.
