Bond Funds: A Look At The Potential Downside
People that I know have been asking me about bond funds, and why the prices are falling, and if they should do anything about it -- such as switch from one sort of fund to another. I'm not going to make any recommendations here, but I think it is worthwhile to look the downside risk in the bond funds we have grown to love in the last few years of falling interest rates. And if you've got a lot in bond funds, ask your financial advisor what he or she thinks. My general conclusion is that if rates keep rising, and hit the recent modest highs of early 2006, longer-term bond funds would see prices fall by as much as 10 percent.
I'll first give a refresher in how bonds work. (I know it's obvious to many readers.) The returns you earn on bond funds are made up of (1) the interest which the bonds in the fund pay and (2) changes in the price of the bonds (positive or negative). Rates go up, prices go down, and vice versa.
The price changes are the result of changes in the yields on the fund's bonds. The biggest factors here are market interest rates, such as the direction of U.S. Treasury bond yields, and the credit premiums on corporate bonds. When corporate profits are good, investors demand a smaller credit premium, which compresses the yield and sends prices up. That applies to high quality, investment grade corporate bonds, and to high yield corporates even more so.
Back to the markets. As I wrote a few days ago, interest rates are generally rising. Most economists think the explanation is an improving economy and rising demand for money.
As measured by the 10-year Treasury yield, rates bottomed in early October at about 2.4 percent, and are today at 3.4 percent.
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The table below shows what the impact has been on a variety of bond funds. The first column shows the recent high price in several funds, before interest rates started to drop; the second shows the price on December 23; and the third shows the drop in price. I refer to Vanguard funds simply as examples -- I am not endorsing them.
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The two shorter-term funds, at the top, have suffered the least, losing less than two percent in price. That is part of bond math. The longer term funds are down between 2.7 percent and 4.2 percent. The long-term municipal fund is down nearly six percent; in addition to higher rates, that drop probably reflects the market's concern over state and local government financial health. My MoneyWatch colleague Allan Roth has written a nice story on that topic.
More bond math: for each bond you can calculate a measure known as duration. It's a shorthand measure that tells you how sensitive a bond is to changes in its yield -- the price of a bond with a duration of five years, for example, would drop five percent for each one percent increase in yield. So far, the changes in the bond fund prices have been roughly what the duration would tell you to expect from the recent rise in Treasury yields. This is summarized in columns 5, 6 and 7 in the table -- column 6 is the actual price change; 7 is estimated from each fund's duration times the 0.85 percent rise in 10-year Treasury rates since October.
Now the punch line: column 8 shows the first-quarter 2006 low for each fund's price, when the 10-year Treasury yield was at about five percent. Column 9 compares that to prices today, showing one potential outcome. For high yield corporates and municipals, comparison to those levels shows an increase from today's prices, but for the other bonds, owners may be looking at losses approaching 10 percent. Compare that to column 4, showing each fund's "SEC yield" (it shows you the annualized rate of yield based on where things are today).
Caveat: this analysis is one-dimensional and assumes lots of things won't change from how they are now, but it's a starting point.
The potential drops in price are equal to a year or two's income. However, if rates do rise -- and it is not difficult to envision the 10-year bond at six percent before long -- the funds will be able to invest in higher yielding bonds to offset that. I wrote a note on that a few weeks back, positing that with a sharp rise in yields, investors likely would recover after a few years. But I know how difficult those years can be.
Seriously, it's time to look at your bond funds. Maybe move to a shorter maturity to cushion against loss in principal, or even think of switching to a conservative stock portfolio to take advantage of the improving economy. But you must understand how powerful rising interest rates can be.