The following is in response to Raul Elizalde’s article, Why Bond Funds are Toxic for Your Portfolio, which appeared last week:
Dear Editor,
There are two important quotes from Elizalde’s article: “Bond funds will not provide the safety that investors seek. Holders of individual bonds will fare much better.” and “The level of 10-year interest rates today is a strong forecast of the return of a bond fund over the next 10 years.”
These two statements cannot both be true. If we are to believe his chart on 10-year Treasury yields as a predictor of bond-fund performance (which I tend to believe), then we are left with the conclusion that bond funds will perform very similarly to individual bonds. In fact, according to his chart, the bond-fund strategy outperformed individual bonds through most of the rising-rate environment from 1950 to 1980.
This leaves one question: Was this article geared towards unsophisticated investors, or did Elizalde misinterpret this research?
Best regards,
Jake Carris CFA, CFP®
Tim Looney Investments, LLC
Altamonte Springs, FL
Raul Elizalde replies:
Most professionals today cut their teeth during a 30-year cycle of declining interest rates. But that cycle ended last year and rates are now heading up. In this new world, understanding how bonds funds behave will be crucial to prevent unnecessary losses.
In my example, I imagined a bond-fund manager who, like most portfolio managers, has to keep the portfolio duration within a certain range. This highly simplified example starts with a newly-issued 10-year bond that is replaced a year later with a new 10-year bond that restores the portfolio duration to the mandated range.
To see how the bond fund works, imagine that the original bond is priced at par with a 1.5% semi-annual coupon. If a year later rates go up to 2.5%, the price of the bond, now with 9 years left to maturity, will decline to about 92 (pricing assumes a semiannually-compounded Actual/365 basis). This is a permanent loss of principal that cannot be recovered unless rates later come down.
|
Year |
Bond |
Bond Fund |
|
0 |
-100 |
-100 |
|
1 |
1.5 |
1.5 |
|
2 |
1.5 |
2.5*0.92 = 2.3 |
|
3 |
1.5 |
2.5*0.92 = 2.3 |
|
4 |
1.5 |
2.5*0.92 = 2.3 |
|
5 |
1.5 |
2.5*0.92 = 2.3 |
|
6 |
1.5 |
2.5*0.92 = 2.3 |
|
7 |
1.5 |
2.5*0.92 = 2.3 |
|
8 |
1.5 |
2.5*0.92 = 2.3 |
|
9 |
1.5 |
2.5*0.92 = 2.3 |
|
10 |
101.5 |
92 + 2.5*0.92 = 94.3 |
|
IRR |
1.50% |
1.46% |
The table above shows the cash flows for a 10-year bond and for a bond fund that is liquidated after 10 years. If the manager switches out of a 9-year bond at par into a 10-year bond every year for 10 years and rates remain at 2.5%, there is no further loss of capital. Compared to the holder of the original bond, the bond fund receives higher coupons after the second year, but the IRR of the fund over the entire period is lower due to the loss of principal.
If rates go up another 1% the second year, the remaining $92 will decline to about $85. This is because the PM will be selling the 2.5% coupon bond, purchased at par, at just $92.34 ($92 * 0.9234 = $84.95). Future higher coupons will not compensate for this larger loss of principal. In fact, if rates continue to climb, eventually this bond fund will have a negative IRR over the 10-year period, while the holder of the individual bond will always receive the 1.5% promised return.
This effect can be seen at work in real life: Bond funds have suffered huge losses with the recent increase in rates, as I cited in my original article. While bond-fund holders may receive higher yields because of higher bond coupons, there is no doubt they will register another round of large losses a year from now if rates go up, say by another 1%. The large redemptions suffered by bond funds show that investors understand how this works, despite what managers tell them or whether advisors understand it.
