The Downside of Bonds

The cover of this week’s Barron’s reads “Trouble Ahead for Bond Funds.” It refers to an article discussing the downside of holding bond funds in the current environment. Specifically, the article discusses the risk of a decline in prices should interest rates rise.

Someone reading just the approximate first half of the article may think they should completely abandon bond funds. After all, there is validity in the warning. When interest rates finally do rise, the value of the bonds held by these funds will decline. Should interest rates stay fairly stable for longer than expected, then the returns will be lackluster due to the low level of yields.

This doesn’t sound like a very good choice, but the role of bond funds in the current environment should not be to realize decent returns. Rather, bond funds should be used to provide diversification. Holding bond funds can offset the volatility of stocks and allow you to sleep at night. Even Barron’s makes this argument deep into the article.

Consider the likelihood of a 20% drop in stock prices, which is considered to be a bear market. There have been 12 bear markets since World War II. Though there is no expiration date on the current six-year-old bull market, at some unknown point in the future the S&P 500 will have a drop of this magnitude. It’s simply something that is part of the normal return cycle for stocks. For a high-quality bond fund to fall by 20%, interest rates have to jump. The magnitude of the jump depends on interest rate sensitivity of the bond fund, but for an intermediate-term bond fund, interest rates would have to rise by about four percentage points. Nothing Fed Chair Janet Yellen said in yesterday’s or today’s testimony suggested a big enough change in monetary policy in the foreseeable future to move interest rates to that extent.

The four-percentage-point interest rate move is based on a measure known as duration. For each year of duration a bond fund (or a portfolio) has, it will lose 1% of its value for each full percentage point increase in interest rates. So an intermediate-term bond fund with a duration of five years will lose 5% of its value if, say, interest rates rise from 2% to 3%. There are, of course, other factors at play, including credit quality, bond liquidity, expectations for future monetary policy and the overall risk tolerance of investors. All of these factors can influence a bond fund’s actual value. Plus, as interest rates rise, so may the fund’s distributions—assuming the fund manager adjusts the portfolio to hold bonds with bigger coupons (interest payments).

A stock fund’s value can also be impacted by various factors. But over time, stock funds are more volatile than bond funds. The average large-cap stock fund tracked in our Quarterly Low Load Mutual Fund Update had a total risk index of 1.06 at the end of the second-quarter. The average intermediate-term government bond fund had a total risk index of 0.32 and the average long-term general bond fund had a total risk index of 0.63.

These numbers show why holding bond funds in the current environment still makes sense for those who have been previously unnerved by downward volatility in stock prices. Bond funds can provide some stability to an overall portfolio and help to calm your nerves enough so you don’t abandon your long-term allocation strategy.

http://www.econmatters.com/2015/07/the-downside-of-bonds.html