"Safe" is not a lightly used term when it comes to investing. It's a four-letter word indicating the absence of risk - something commonly associated with owning individual stocks. Bonds on the other hand, are often thought to be "safe," and the same is often associated with mutual funds that hold bonds. Yet as this week has shown, bonds, and more specifically bond funds are anything but safe.
Much is due to the fact that for the first time in the past year, interest rates are starting to rise. As rates rise, bond prices fall - and vice versa. Recently, with rates at historically low levels, bonds and bond funds have performed well for investors, providing gains on top of income from interest. However, with signs that the economy is starting to improve, and the Fed indicating that it may stop pumping cash into our economy, folks that own bond mutual funds could be in for a ride.
Here's the difference between bonds and bond funds. You buy $10,000 worth of bonds paying 5% interest, maturing in five years. You'll collect $500 in interest each year, and at the end of five years, receive your $10,000 investment back. A simple illustration, but you get the idea. Now let's say that during your second year of owning the bonds, rates rise and the price of your bonds fall. You'll see the price of the bonds drop on your statement, but you'll collect your interest, and at maturity, you get your money back.
Bond funds however, have no maturity date, meaning that if rates rise and the prices of bonds fall, your fund will decline in value - only there is no point in the future when the fund will mature and you get your money back. You'll still collect your interest from the funds, though it's not all black and white here either. Since bond funds hold several different bonds within them, there is no set rate at which interest will be paid out - it depends on bonds held within the portfolio. As bonds within the fund mature, they're replaced with newer ones - and with rates as low as they've been, newer bonds are paying less interest, requiring many funds to reduce their payout rates.
So we now have bond funds that are paying less interest, and placing your principal investment at greater risk should interest rates continue to rise. Safe? I think not.
(This article contains the current opinions of the author but not necessarily those of Brighton Securities Corp. The author's opinions are subject to change without notice. This blog post is for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities).