If you feel clueless and invest 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. Please read this before investing money (or more money).
Truly safe investments pay interest and their principal 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: bank savings and checking 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) they have in their investment portfolio (such as stocks) fluctuate. People invest money here to get HIGHER INTEREST INCOME vs. really 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, whose price per share is set at $1 per share. You need to 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 (your own) in high-quality debt securities of government entities or corporations; others go for the higher yields of lower quality or even junk bonds. In 2014 and 2015: that’s not the big problem.
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 hold notes that mature (on average) in 25, 30, or 40 days. In other words, they invest money in high-quality IOUs that promise to pay them 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 is not the case with income funds that invest money in promissory notes maturing (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. If they are $1,000 notes that promise to pay 3% interest per year ($30), they are priced (or valued) around $1,000 when 3% is the prevailing rate for similar notes in the bond market. Remember that bonds are traded on the bond market just like stocks are traded on the stock market. Now, what would happen to the price (value) of this note if the prevailing interest rates went up to 6%, 7% or more?
Investors in the market would still buy and sell 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 must understand this.
All income 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-, medium-, and long-term bond funds. As you move from left to right, the dividend yield (interest earned and paid on dividends) increases. More importantly, 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 the current interest rate environment they offer paltry interest income. Long-term bond funds can yield 3% or a little more (depending on quality), but the interest rate risk is HIGH. Medium-term funds can 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 all-time lows. This means that when you invest money in long-term income funds just to earn 3% or 4% in interest income, you are accepting considerable risk to earn 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 are not really safe investments for 2014 and beyond. Interest rates could go up.