If you’re feeling clueless and investing money in bond funds, you should know that your funds could bite you in 2014. Bond funds are NOT safe investments and some are riskier than others. Read this before you invest money (or more money).

Truly safe investments pay interest and their capital is safe or fixed. Safe investments do not fluctuate in price or value and may be insured or even guaranteed by a federal government agency. Examples include: checking and savings bank accounts, certificates of deposit, and Treasury bills. Bond funds also pay interest, in the form of dividends. Their price or value DOES fluctuate as the prices of the debt securities (bonds) you hold in your investment portfolio (such as stocks) fluctuate. People invest money here to get HIGHER INTEREST INCOME vs. Truly safe investments. That is why they are also called income funds.

Bond funds are RELATIVELY safe investments, compared to stock funds. But they’re not even close to being as safe as money market funds, which are priced at $1 per share. You should understand this before you invest money in income funds: your investment can go up in value and it can go down. Some funds invest money (yours) in high-quality debt securities of government entities or corporations; others opt for lower quality higher yields or even junk bonds. In 2014 and 2015: that’s not the big deal.

While money market funds invest their money in very short-term notes, bond funds buy and hold long-term debt securities (notes called bonds). A money market fund may have notes that mature (on average) in 25, 30, or 40 days. In other words, they invest money in high-quality promissory notes that promise to pay you back in a matter of days. Because debt securities held in money market funds are so short-term in nature, their value fluctuates little and they are considered safe investments. The same does not happen with income funds that invest money in promissory notes with maturity (on average) in 5, 10, 15, 20 or more YEARS.

The main issue in 2014 and beyond for bond funds is called “interest rate risk.” Imagine a fund that has notes that (on average) mature (repay the owner) in 20 years. For $1,000 notes that promise to pay 3% annual interest ($30), they are priced (or worth) around $1,000 when 3% is the prevailing rate for similar notes in the bond market. Remember that bonds trade in the bond market just like stocks trade in the stock market. Now, what would happen to the price (value) of this note if prevailing interest rates rose to 6%, 7%, or higher?

Investors in the market would still be buying and selling this note…but the price would drop significantly…because now investors can get 6% or more ($60 a year or more in interest) on other notes because that’s the kind of current interest. This is an example of interest rate risk in action, which is why bond funds are not safe investments. If you invest money in these income funds or plan to do so, you need to understand this.

All annuity funds will include in their literature a number (expressed in years) called AVERAGE MATURITY. Examples: 3.42 years, 7.15 years, 18.7 years. From left to right, these three examples would be called short-term, medium-term, and long-term bond funds. As you go from left to right, the dividend yield (interest earned and paid in dividends) increases. More importantly, your interest rate risk increases dramatically as you move from short-term funds to long-term funds!

Short-term funds are relatively safe investments, but in today’s interest rate environment they offer measly interest income. Long-term bond funds may yield 3% or more (depending on quality), but the interest rate risk is HIGH. Medium-term funds may yield between 2% and 3%, but still carry a significant amount of interest rate risk. If interest rates double or more in 2014 and beyond, investors in longer-term funds could see losses of 50% or more.

The last time interest rates spiked was in the late 1970s, peaking in 1981. Investors holding long-term bond funds lost almost 50%. Today’s interest rates are near record lows. This means that when you invest money in long-term income funds only to earn 3% or 4% in interest income, you are accepting considerable risk for a measly income.

Bond funds have basically been good investments since 1981…because interest rates were falling, which increases the value (price) of these funds. Now, you know the rest of the story. Bond funds aren’t really safe investments for 2014 and beyond. Interest rates could go up.

Leave a Reply

Your email address will not be published. Required fields are marked *