Why Bond Funds are Toxic for Your Portfolio
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Thirty years of rate declines have convinced many that bonds are safe. Indeed, a conservative portfolio has come to be synonymous with one that is heavy on bonds. But a rising interest-rate cycle is taking hold, and bond investors are now exposed to unfamiliar risks in their conservative portfolios. Bond funds will not provide the safety that investors seek. Holders of individual bonds will fare much better.
Interest rates have long cycles. They rose between 1898 and 1920, dropped between 1920 and 1940, climbed again to historic highs between 1940 and 1981 and then plunged to historic lows between 1981 and 2012. For the last 125 years, rates have behaved in cycles that lasted decades. A new cycle started about a year ago, when the U.S. Treasury 10-year note rate plummeted to about 1.5%, a record low and below the likely rate of inflation in the next 10 years. Barring deflation, such low interest-rate levels will not be around again for a long time.
Investors who hold individual bonds are only marginally affected when interest rates go up if they keep their bonds to maturity. Payments are fixed regardless of whether interest rates go up or down. Unless the borrower defaults, the scheduled payments remain the same.
There is a big difference between an investor who keeps an individual bond until maturity and one who doesn’t. While the former will get all the payments as promised, the second one will not, because he or she will sell the bond at a lower price.
This is the inherent problem with bond funds. Bond fund managers almost never hold bonds to maturity. Bond funds are typically defined by maturity targets (short-term, intermediate-term and so on), and as time goes by, holdings are rebalanced to keep the fund's average maturity constant. To do so, managers replace shorter bonds with longer ones. When interest rates go up, they sell bonds that were acquired at higher prices when interest rates were lower, realizing losses.