Consider Individual Bonds Instead
Most bond funds, including many of those offered in your 401K plan, are much more dangerous than they seem. They could be a ticking time bomb in your retirement account. You might think that they are boring investments that are less risky than stocks and give comparably lower returns. However, this conventional wisdom is incorrect on both counts.
First, bonds have been a very good investment over the past 30 years, offering returns that rival that of equities (stocks). This alone should give you pause because any investment that rivals the returns of stocks can be as risky as stocks. Why? Because in the long run, risk is proportional to return. More return means more risk.
You might think that you can't lose your principal when you invest in bonds. Not true. You can lose your principal for a number of reasons, which I will explain briefly.Credit: flickr-creative commons
Terms You Need to Understand
Before I explain why bond funds are risky, you might need to know these terms.
Principal is the amount of money that you invest. When a bond matures, assuming that the issuer does not default, you get your principal back, plus interest.
The total return of owning the bond. Yield comes from two parts, from changes in the market value (which changes with market conditions) and the coupon payment (which is fixed).
The length of time until a bond matures.
The risk that the issuer defaults on the loan. In a default, you typically lose between 50 to 90% of your principal.
Interest Rate Risk
The risk that rising interest rates cause the market value of a bond to decrease.
The Bond Book
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Why are Bond Funds Risky?
Bond mutual funds are risky because of interest rate risk. Individual bonds (from now on, referred to as individual securities) are susceptible to interest rate risk also. However, individual securities have a maturity date, at which time 100% of your principal is returned, unless the issuer defaults. Bond funds, in contrast, never mature. They are made up of hundreds of individual securities, with different maturity dates. There is no future date when your principal is returned. Thus, your principal is at risk.
Interest Rate Risk and Duration
Interest rate risk increases as the duration of the security increases. A 30 year bond (or a long duration fund) has substantial interest rate risk. A 2 year bond has minimal interest rate risk. For individual securities, a rising interest rate does not result in lost principal, unless you sell them before maturity. However, there is an opportunity cost to holding until maturity. The money that is stuck in the low yielding security could yield more if it were invested at higher rates.
For an analogy, think about certificates of deposit (CDs). Suppose you bought a 10 year CD that yields 2%. A year later, interest rates have risen and a 10 year CD now yields 4%. You kick yourself for buying that CD because now your money is only earning 2% when it could be earning 4%. That is opportunity cost. The same situation applies to a bond, except that bond prices fluctuate. When interest rates rise, bond prices decline. So if you were to sell after interest rates rose, you would lose principal.
Why are Bond Funds Even More Risky Today?
Bond funds today might even have more interest rate risk than they have had in the past. Bond prices have risen for about 30 years. That bull market might continue for a while longer, but most professionals think that the next big move will be down. Nobody knows when this will happen, of course. But the odds favor rising interest rates and falling bond prices. If this happens, and you have a large exposure to long duration funds in your retirement account, you will suffer large losses of your principal.
How Can You Protect Yourself?
If you want bonds in your portfolio, consider these alternatives to funds.
You can buy highly rated individual securities of short duration (5-7 years or less). As discussed before, as long as you hold individual securities to maturity and the issuer doesn’t default, your principal is safe. Individual securities, however, have other problems. First, they have default risk. To reduce this risk, buy the ones that are highly rated (A or better). The other problem with buying individual securities is that you need at least $50,000 to buy a diversified portfolio. For example, with $50,000 you could buy 10 individual securities at 5,000 each. Finally, you usually can’t buy them in a 401K account.
But if you have enough money to diversify and you have an IRA or a taxable brokerage account with access to a bond desk (like Etrade), then buying individual securities is definitely better than buying mutual funds. Commissions are modest. If you are not comfortable buying individual securities yourself, you can pay more and get guidance at a full service brokerage.
Short Duration Funds
If you are not able to buy individual securities in your account, then stick with short duration funds (3-5 years or less). Funds with a shorter average duration have less interest rate risk. To find the average duration of the bonds within a fund, see the prospectus.
I am not a financial adviser or an accountant. This information is provided only as a suggestion for further research. Before you make any investment decisions based on the information presented here, you should contact a certified financial adviser.