Bonds, Bond Funds, and Interest Rate Risk

img.jpg

Question: Years ago I was warned not to buy a bond mutual fund because if there was inflation the value of the fund would go down and I wouldn’t get my original investment back, but it was OK to own the bond of a good company because then I would get my original investment back even if its value was less because of inflation.  Is this true?

Answer:  You are referring to “interest-rate risk.”  When you buy an individual bond, you are buying a promise from the issuer to pay you a fixed amount of interest over a stated period of time and to pay you the face value of the bond when the bond matures.   But if interest rates rise after you buy the bond, you are stuck with the lower interest rate your bond is paying.  That reduces the value of the bond. 

For example, if you paid $100,000 for a 10-year U.S. Treasury Bond paying 2% and in twelve months 10-year Treasuries were yielding 3%, you wouldn’t be able to sell your bond for $100,000.   A bond buyer would want a 3% yield, so they would only be willing to pay you an amount that would equalize the $2,000 payments to a 3% yield.  If you held the 10-year Treasury bond to maturity you would get your full $100,000 back, but you would have missed out on higher interest rate payments and not kept up with inflation.   

Bond mutual funds own many bonds.  You can buy bond funds that invest in government bonds, mortgages, corporate bonds, municipal bonds, and foreign bonds.  The diversification that results from owning many bonds reduces individual issuer risk, but not interest rate risk.  When market interest rates rise, bond fund share prices will decrease and bond funds that hold bonds with longer maturities will suffer more.  When the bonds in the bond fund mature, the fund will receive the face value of the bond from the issuer.

A crude rule-of-thumb method to measure interest rate sensitivity uses a bond fund's duration, which you can look up on the fund’s website.  If the fund’s duration is 5 years, you can expect the value of fund shares to drop by 5% for every 1% increase in market interest rates.  When investors expect interest rates to rise, they will be looking for low-duration bond funds.

Question: So if I want to own just the basics should I own anything but a total U.S. market index fund and an overseas index stock fund?  Do I need to own things like a real estate fund, an emerging markets fund, a TIPS fund, etc.  What are the bare bones basics?

Answer:  You would be off to a good start with U.S. and foreign total stock market index funds.  You could also just buy a global stock market fund.  Stock market index funds may or may not include real estate securities (REITS) and emerging market stocks in their portfolio holdings.  REITS, emerging market stocks, commodity-linked funds, TIPS (Treasury Inflation-Protected Security) funds, and different kinds of bond funds all add diversification to--and can reduce the volatility in--an investment portfolio.  

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to ken@montereypw.com.