A Looming Problem

by Jeff C. Johnson

Pennies spilled from jar

A bond mutual fund is not the same thing as a bond.

A bond represents the indebtedness of a company, government, or other entity that generally pays a fixed interest payment at intervals, often every six months. A bond has a specific maturity amount (face value) and a fixed maturity date when the principal is paid. Bonds can be short term, paying back principal on a maturity date only a few months away, or long term, with a maturity date sometimes 30 years in the future.

Bonds can be sold before maturity, and they fluctuate in value based on interest rates; when the prevailing rates rise, a bond with a fixed interest payment declines in value. If you wanted to sell, why would an informed person buy your bond that pays a lower rate than readily available? The answer: They can buy it at a discount.

When interest rates decline, your fixed interest bond will rise in value because you have a better bond offering than the available new offerings.

Bond prices move in an opposite direction to interest rates. The longer the term of the bond, the greater the fluctuation in price. To be clear, long bonds due in 20 or 30 years usually pay more interest but also can have more downside when rates rise.

In the future, if interest rates rise, bond investments will decline in value. But if you are patient and hold onto your individual bond until its maturity date, you will receive the interest payments and the full maturity value on the due date, no matter what has happened with interest rates.

A mutual fund invests in a portfolio of securities that can be stocks, bonds, or a combination of these asset classes. When you buy a mutual fund, you own shares of the investment company that can hold a number of different investments, and there is no specific maturity date or amount.

A mutual fund that holds long bonds can pay attractive yields and looks especially good during periods when interest rates decline. Not only does the fund shareholder get the higher interest payments generated by the bonds, but also a bump up in share price valuation due to the increase in price of the bonds as long as rates decline.

Here’s the problem. What happens when rates rise, especially if they rise rapidly?

Since 1982, interest rates have mostly declined from double-digit levels to the low single digits today. There is a generation of investors that has been pouring retirement money into bond funds because they look safe, they have had reasonable returns, and they seem steadier than stock mutual fund choices. They don’t realize that their fund shares can decline, and that the declines can be breathtaking if rates rise quickly.

I have no information that any rapid rise in rates will happen anytime soon.

But it’s not too hard for me to imagine the day when rates rise and 401(k) investors that have government bond mutual funds in their accounts are shocked to find that they have lost significant value in an investment they thought was very safe and predictable.

A wealth adviser can help with understanding the market risk of a bond fund portfolio and suggest an appropriate alternative approach.

In my book The Extreme Retirement Planning Workbook, I've included a chapter that describes the market risk of bonds in general based on changes in interest rates.

This discussion of bonds and values deals only with the market risk of a bond, which is normally the result of interest rates. It does not consider the credit risk of a bond, which is the ability of the issuer to make interest and principal payments when due.