Monday, December 28, 2015

Bond Mutual Funds Aren’t Built to Prevent Losses – You Can Still Lose Money

Bond Mutual Funds Aren’t Built to Prevent Losses – You Can Still Lose Money

Many are the myths that surround financial planning, but one of the most unfortunate and, in my opinion, potentially damaging is the notion that bond mutual funds are safe from value dips. As in, bond funds are the “safe place” to be when you don’t want your portfolio to lose any money.

About a week or so ago, I met someone at a social event who was at the least confused and at best disappointed because his bond portfolio has lost close to 15 percent in value within the past two quarters, since about July. His frustration seems to be more related to his understanding, however wrong, that bonds are the place to go to when you are looking to avoid the value dips usually associated with stock mutual funds – which was precisely what he intended and thought he was doing.

Obviously, he’s now learned the hard way that this truism wasn’t true. But he wasn’t the only one who believed this – so do many other weal-meaning, hard-working folks out there. Actually at the event where I met this gentleman, most of the others in our conversation circle believed this myth to be true: that bond funds are safe and won’t lose money.

How is such confusion possible?

I think the confusion seems to stem from the notion that government bonds are safe investments, and so, by implication, bond funds must be, too. While it is true that government bonds have virtually no default risk (meaning, you’ll get back your original investment at maturity), default risk isn’t the only risk associated with bonds. The other type of risk, which is fairly common and does occur frequently, is market risk. This has to do with declines in the price/value of a bond when interest rates rise. It happens when you try to sell a bond before its maturity date at a time when interest rates are higher than when you originally bought it. I must mention, additionally, that other kinds of bonds (e.g., municipal and corporate bonds) do carry default risk.

Without getting too technical, here’s the thing you must understand about mutual funds (including bond funds) in general: your fund manager has the authority to buy and/or sell whenever he or she sees fit. So if your fund sells bonds before their maturity at a time that interest rates have risen, compared to when those bonds were originally purchased, you’ll lose some value. That’s just how things work. And it is also very important to remember that you, as the individual investor in a bond fund, do not get to make the call regarding when the fund buys and/or sells its holdings.

The best way to mitigate some of this risk is to invest in a fund that holds high-quality short-term bonds. High quality to protect against default risk and short-term to combat market value rate swings.

All my best to you and yours in 2016!

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