I don't have much experience with fixed income investments, so forgive my ignorance.My parents recently moved a large amount of their savings from CDs and savings accounts to bond funds because they were tired of their low interest rates at the suggestion of a planner at their bank. They tend to do EVERYTHING at the wrong time because they are scared and think the next asset class will be safe. They lost a lot in stocks in the dot com era. Now they will never buy stocks again. They lost a lot in REITs after the real estate bubble (since real estate is safe, not like those stocks!) And now, they are just now deciding they can't stand their sub 1% interest and need to move into a bond fund because those are safe and have been doing so well.I have no special knowledge of when our low interest rate environment will become an extended rising interest rate environment, but it seems possible that it could happen eventually.I am certain my parents are not willing to risk their principal for a higher current income. (They do not care when I explain real versus nominal losses, they are very emotional about money.) What is the worst case for a bond fund holder with no plans to reinvest any income received? Financial planners love to point to the last 10 years of returns, but they gloss over discussion of what could happen. I asked my mother if the planner mentioned that she could lose some of her principal and she said that he did explain that but that "they buy and sell all the time so they would end up buying the higher yield investments." Of course they do.. the buying and selling is the only cause of the loss in nominal value.Sorry, I buried my question in a wall of text:What is the worst case for a bond fund holder with no plans to reinvest any income received? What happened to someone who bought into bond funds at the worst time in the 1970s, for instance?
What is the worst case for a bond fund holder with no plans to reinvest any income received? Two bad things could happen:1. Interest rates go up, and share prices drop significantly, so you realize a loss when a time comes you have to sell. Note that if you continue to hold, at least you will start to see rising dividends.2. Interest rates don't go up, and the return from dividends goes down as bonds in the portfolio are turned over. What happened to someone who bought into bond funds at the worst time in the 1970s, for instance? Depends on how long they held. Bond prices would have gone down, but the current yield would have gone up, then down again. Bill
What is the worst case for a bond fund holder with no plans to reinvest any income received?Depending on the duration* of the funds (you can look the funds up on Morningstar), it could be rather bloody.The bad news with were we currently are with bonds** is the fact that we need not even need to have interest rates go up for bond funds to lose value. The flow of money from bonds to stock will cause prices to deflate. The whiff of a change in monetary policy could have the big players headed for the doors before your small investor has any chance to do anything.How bad can it be? Look at what those investments did from October 2008 through December 2008. Sure, bonds came back quickly in 2009 but in an inflationary environment, that is not likely to happen as fast.*Duration is a measure of interest rate sensitivity. A fund with a duration of 4.00 will typically lose 4% value when interest rates move up by 1%, and vice versa.You asked about the 1970s but I don't think that is a good example. Interest rates on the 10 yr went from about 6% to 15% during that time and bond funds still were slightly positive - but not accounting for inflation and there was no cooresponding increase in yield.What we have today is very different. Rates have been artificially low for a long time with many bonds in funds maturing with no other investment options but to buy lower interest offerings. We have two problems that make the situation worse - long term low rates and vastly inflated prices. Some treasuries are trading at 140% of their face value. Investments like that don't need an increase in rates to see prices drop as maturity approaches.Back to 1970. When rates went from 6 to 15, that is an increase of 150%.Rates today are below 2% We only need to see rates go to 3.5% to have the same percentage increase.**Depends on the type of bonds. High Yield, international, emerging market, and floating rate (which are actually loans, not bonds) are better positioned to weather an increase in rates.
Good previous answers. Bond funds are basically a business that invests in bonds. If business is good the share holders do well, if business is bad the share holders do poorly. Its almost like investing in a commodity company like X (united states steel) when steel is needed X tends to do well, when steel isn't needed X limps along. The greatest risk is principal loss. Currently a commercial grade bond fund holds primarily bonds bought at a premium because much of that portion of the bond landscape has been priced with a premium for a long time. As interest rates rise that premium will dwindle if not completely disappear. Duration of a fund also dictates buying and selling; funds tend to hold a range of maturities, outside that range they buy or sell. For years these mid and long range funds have been forced to sell and buy into a rising market. It all looks good on paper, but over paying for anything rarely ends well. A long time ago this board conducted several studies on what bond funds are likely to do through multiple up and down cycles. The primary conclusion is that if one reinvests the dividends the higher yield does not make up for the loss in principal. If one does not need to tap into the principal the rising dividend yield might be beneficial but it will not off set the loss in principal. If they ever need to start drawing down on the principal they will be eating a significant loss.jack
There's an important difference between buying a bond fund (or ETF) and buying the actual bonds themselves.With a bond fund or ETF, when interest rates go up (and they will), the value of the asset will generally go down -- and so your parents will lose PRINCIPAL (which, you say, they absolutely do not want to do).When you buy the actual Treasury notes (bonds, bills, whatever), you can be certain that if you hold the bond to maturity you will get your principal back. And the interest payments are gravy. The problem, of course, is that you will have to reach into fairly long maturities (i.e., longer than 10 years) to make more than 2 percent per annum.Welcome to financial repression. I am NOT an advisor of any kind. But with a reasonable balance of, say, Vanguard ETFs (Total US market, REITS, bonds, international), they will almost surely do better than 100 percent in bonds. And that goes double for 100 percent in bond FUNDS (or ETFs).Anyone else, please feel free to correct anything I have said here.
<<< When you buy the actual Treasury notes (bonds, bills, whatever), you can be certain that if you hold the bond to maturity you will get your principal back. >>>Unfortunately your principal might not have the same amount of buying power because of inflation.Norm
MisterFungi,I agree diversity is the way to go and fear driven investing is absolutely the worst kind of investing virtually guaranteeing a beating.jack
Thank you all for your answers. They were very helpful.
Unfortunately your principal might not have the same amount of buying power because of inflation.Might? Has there ever been an appreciable period of time in which this wasn't true?
Unfortunately your principal might not have the same amount of buying power because of inflation.Might? Has there ever been an appreciable period of time in which this wasn't true? Yes: Following the Panic of 1837: which was spurred by all banks' insistence on accepting payments in either silver or gold coinage alone, the US economy decreased by almost 30%.The Great Deflation: From 1870-1890 there was a drastic decline in the prices of goods, raw materials, labor and services throughout US. The cause of this deflationary period is attributed to the return to gold standard post Civil War. From 1876-79, the price level fell on average almost5 percent per year.The Great Depression:Years when the CPI was negative:1926 -1.5 percent 1927 -2.1 percent 1928 -1 percent 1930 -6 percent 1931 -9.5 percent 1932 -10.3 percent 1938 -2.8 percent 1939 -0.5 percent Other years when the CPI was negative1949 -1.8 percent 1954 -0.5 percent Source: Ibbotson Associates http://www.azcentral.com/news/articles/2008/11/24/20081124bi...References:http://www.buzzle.com/articles/historical-periods-of-deflati...http://research.stlouisfed.org/publications/es/10/ES1030.pdf...
So can deflation occur again???A few comments about today’s Bernanke testamony:Doug Kass (Seabreeze Partners): Opps, Bernanke almost just admitted to..."pushing on a string." Agnes Crane (Reuters reporter)Bernanke says premature tightening could cause inflation to fall further. But it's falling with QE. How do they get out of this thing? Inflation or Deflation?Place your bets!
So can deflation occur again???The Fed is scared about deflation and is doing all it can to prevent it. A few comments yesterday from James Bullard, president of the Federal Reserve Bank of St. Louis:http://online.wsj.com/article/BT-CO-20130523-705172.html?mod...Inflation in the U.S. needs to climb back toward the 2% target before the Federal Reserve should consider slowing the pace of its asset purchases. He is "nervous" about the fact annual inflation in the U.S. has been trending down. Annual inflation slowed to 1.1% in April, or 1.7% excluding food and energy prices. He "would like some reassurance" from the economic data that inflation "is going to turn around and go back towards target before we start tapering," using Fed lingo for reducing the pace of its asset purchases from $85 billion a month. Mr. Bullard currently holds one of the voting slots on the Fed's rate-setting panel that rotate among regional central bank chiefs. He said he expects the unemployment rate in the U.S. to slow to around 7% by year-end. The Fed has said it won't touch short-term rates until unemployment slows to 6.5%. Mr. Bullard said 6.5% is a threshold and not an automatic trigger for Fed action.
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