Bond Fund Investing 101
Bonds can be an important component of a portfolio’s asset allocation strategy. Understanding the nuances among the different types of bonds and the role they play in portfolio composition is key in considering them as part of your overall investment strategy.
What is a bond fund and how does it work?
Bond funds invest in bonds and other interest-earning securities issued by governments and corporations. Bonds are sold to raise money—to build factories or bridges or to expand public services, among other purposes. Bonds promise to pay fixed interest payments and, at the end of the loan (called the bond’s maturity), to pay the original investment (principal). Bond maturities generally range from 1 year to 30 years. In general, the longer the maturity, the higher the interest payments; the market will pay more for a longer loan. Conversely, the longer the maturity, the greater the risk, as bonds are interest rate sensitive. A bond’s promise to pay interest and repay principal is only as good as its issuer’s financial strength. The stronger the issuer, the higher the quality of the bond. All things being equal, high-quality bonds will pay lower interest because they’re safer; the market will pay less for a less risky loan.
What’s the relationship between bonds and interest rates?
As interest rates rise and fall, the value of a bond rises and falls in the opposite direction. Investing in a general bond fund does NOT guarantee that you’ll lose money in a rising interest rate environment – although it does guarantee you’ll face some valuation headwinds. Several factors determine whether or not you’ll make or lose money on an absolute basis in bonds.
First, it depends on how much rates rise. If they rise slowly over time, you’ll be reinvesting principal at ever more opportune rates. Thus, if a 2.5% coupon bond fund only loses .25% per quarter to lower valuations from higher rates, you’ll still make 1.5% annually plus the higher reinvested coupons going forward.
Second, it depends on how fast rates rise. If rates rise quickly you’re more likely to lose money on the bond fund in a short period of time – but you’ll begin making a higher return than you did previously once rates stabilize.
Third, it depends on the nature of interest rate increases. If short term rates go up, but long term rates stay relatively stable, you could very well see positive returns from longer-dated bonds.
Fourth, it depends on the duration of the bond fund. Long duration bonds (those with long maturities, i.e. more than 10 years) will show more negative price changes for every percentage point increase in rates. Any meaningful increase in long term rates will likely condemn long bond funds to periods of negative returns while rates are this low.
What’s the difference between a general bond and a municipal bond?
Municipal bond markets are different from other bond markets in some important ways. Their ability to generate returns for a particular investor are tied to that investor’s tax rate. Lower tax rates reduce a tax-exempt municipal bond’s efficiency. This means that municipal bonds are also less correlated to interest rate changes than corporate or US Treasury bonds. All other things equal (which they never are), municipal bonds may lose less value as rates rise IF tax rates for affected jurisdictions remain high or increase, or if other competing investments (CDs, bond funds, etc.) also become even less attractive. For instance, if corporate bond defaults begin to accelerate while municipal rates remain relatively unchanged, this could drive down corporate bond returns faster than tax-related changes would hurt municipal bonds. Of course, taxable municipal bonds are another option. This sector gives an investor exposure to municipal credit risk (as opposed to corporate credit) with less exposure to tax rate change issues.
Bond fund investments may be a good option for investors willing to accept moderate risk who may not need their money for at least several years. While we cannot advise a client to divest of an asset class (or for that matter, purchase one), what we can do is guide clients to ask the questions that are important, and find answers that make sense so that each individual can make their own decisions based on what is best for their individual circumstances.
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