Bond Funds: What's Going To Happen To All Those Bonds We've Bought?

In view of the parade of terrible news on the U.S. economy, and the stated commitment by the Federal Reserve to keep interest rates low for as long as it needs to, the people who have been buying bond funds for the past several years probably don't have a lot to worry about in the near term. Some day, however, interest rates will head back up and bond prices will come down. There are escape routes, though, and bond investors should know how to react.

In the past week or so I have read in several places about the giant purchases of bond funds by U.S. retail investors. And this morning my dog park friend Larry, a financial guy, was talking about bonds too, so I figured it's time to mention them.

Here's a picture that compares net new cash flow to stock funds (the green line) and bond funds (the red line), since 1984 (it would be better as a bar chart but Excel is not cooperating today):

Click on the graphic for a larger image
Investors stopped buying equity funds in 2007, and switched into bond funds -- to a great extent what the Investment Company Institute calls "strategic" funds which invest opportunistically in many areas of the bond market. From 2007 through June 2010, investors have purchased $655 billion of bond funds. That's not as much as people bought in stocks in the four years leading up to the tech bubble, $881 billion, but it's close.

It reminds me of the mid-to-late 1980s, when the flavor of the day was GNMA mutual funds. Investors bought about $100 billion of them in 1985 and 1986 -- that was real money then.

Here's why: the 10-year Treasury yield fell from about 13 percent in mid-1984 to about seven percent by the start of 1987. Then rates turned around and rose to about nine percent by April 1989 -- not the sort of thing bond owners enjoy. Investors stopped buying during 1987, and sold about $30 billion in 1988 and 1989.

Bond investors are set up for a much bigger disappointment today. When interest rates start rising again -- nobody wants to venture a guess on the timing -- prices will fall and investors will be inclined to sell.

But selling out is not how to handle it, say the helpful people at Vanguard Group, the mutual fund giant. (Bond investors should read this report.)

As of July 1, 2010, the yield on the Barclays Capital U.S. Aggregate Bond Index stood at 2.9%, with a weighted average duration of 4.6 years. In the most simplistic of examples, a 1 percentage point rise in yields during a 12-month period would lead to a new yield of 3.9% and a capital loss of -4.6%. All else being equal, the expected total return during that period would be the average of the starting and ending yields -- 3.4% -- plus the capital loss associated with the rising yields (-4.6%) or -1.2%. And the good news is that, all else being equal, following the 1 percentage point rise in rates, the initial expected return for year 2 is 3.9%, instead of 2.9%.

But what happens if interest rates unexpectedly rise by a significant amount, say 4 percentage points across the yield curve?

[I]n year 1, the price decline is significant, leading to the potentially worst 12-month return ever for U.S. bond investors (historically, the actual worst 12-month return for the Barclay's Capital U.S. Aggregate Bond Index was -9.2% during the 12 months ended March 31, 1980).

For a total return investor, the new yield level starting in year 2 is of perhaps greater importance. Following the initial year of pain, that same investor would expect a 6.9% return going forward, all else being equal. And two years following the hypothetically worst bond market return ever, the diversified bond investor would be close to breaking even, simply by reinvesting interest distributions.

Click on the graphic for a larger image
So the math says you should hang on, and reinvest your income in the rising interest rates. That would be a very difficult couple of years, during which you would probably get several calls from the broker who sold you the bond funds, exhorting you to dump them and buy some stocks, to take advantage of the improving economy. But eventually the math would work in your favor and get you back to even.

Like I said earlier, I don't know when interest rates will rise, but I am convinced they will. And it will happen fast. In 1987, 10-year Treasurys went from about seven percent in January to 9.5 percent by early October.