I was reading an article this week about bond funds. The subhead read, “The trick next year will be to avoid losing money.”
The first sentence should have been “Don’t buy bond funds.”
What should the line after that have read?
The writer could have saved himself 700 words, taken the afternoon off and caught a matinee. Instead, he wasted readers’ time showing them how little they’d lose if they bought the “top bond funds” featured in the article.
Why will bond funds be near-certain losers next year? It has to do with the mechanics of a bond.
When interest rates rise, bond prices fall. Say you buy a bond yielding 5%. Next year, the Fed raises rates a full percentage point. That 5% yield is not quite as valuable in a higher interest rate environment – not when you can get an identical bond for 6%. So the price of the bond falls (increasing the yield).
But none of that matters if you plan on holding the bond until maturity.
If you bought the bond at par ($100), and the price dips to $90, you’ll get only $90 if you sell it – instead of $100. But if you hold it until maturity, you’ll get your full $100.
So there’s nothing wrong with owning individual bonds in your portfolio – if you plan on holding them to maturity. In fact, I recommend it.
Bond funds are different.
When you buy a fund, the price of the fund is based on the value of the assets.
So let’s say the bond fund has 1 million shares outstanding, and the fund manager buys $20 million worth of bonds at $100 each. The fund price would be $20 ($20 million divided by 1 million shares).
Then interest rates go up, and the bonds decline in value to $90 each. The price of the fund drops to $18. As with individual bonds, if you sell now, you’ll take a loss. But unlike owning individual bonds, the fund never matures.
Those original $20 million worth of bonds will eventually mature, sure. But the fund manager is unlikely to keep them in the portfolio. He has no reason to.
Fund managers are usually incentivized to beat specific benchmarks like a bond index. For that reason, they notoriously overtrade their portfolios.
For example, the largest actively managed bond fund, the PIMCO Total Return Institutional Fund (PTTRX), turns over its entire portfolio nearly five times every year. The next largest bond fund, the Metropolitan West Total Return Bond Fund (MWTIX), buys and sells its entire portfolio three times a year.
Not only does all that trading run up costs – it ensures investors will realize losses as rates go higher.
Unless there is a shock to the system and interest rates head lower, bond funds are a nearly guaranteed way to lose money next year.
It’s not always easy to make money in the market, but it can be easy not to lose it. Don’t buy bond funds.