The financial services industry is quick to turn any new investor distress into a hopefully profitable if sometimes dubious investment product.
Take bonds, for instance. Investment quality bonds, bought and held to maturity, are among the safest and most predictable investments. Annual income is a function of the coupon rate, and you get your principal back at par on maturity, plus or minus any discount or premium on price you paid up front and less commission. A bond ladder, stretching from 5 to 30 years, depending on available resources, locks in a secure income floor throughout the retirement period, a rock-solid way to sleep well at night.
Why would you need to “improve” bonds? Well, in the low rate world since the 2008 crisis, they don’t yield as much as they used to, so a bond ladder can be relatively expensive. Safety during and after a financial crisis, it turns out, is expensive. And bonds are not very liquid. Small investors pay high commissions on what are essentially opaque trades between specialized brokers—there’s no open bond exchange where prices are set and published every day. “Small” means any bond order less than a million dollars, so owning individual bonds works best if you have significant resources. Treasuries are an exception—anyone can buy them direct from the government online without a middleman, but only for taxable, not for retirement accounts (Maybe that’s one thing the Treasury could do to improve retirement planning options).
So years ago the industry started packaging up bonds into mutual funds, and more recently bond ETFs. Daily and intra-day share pricing is readily available, fees are more manageable though sometimes higher compared to equity funds, and the investment company handles all the analysis and brokerage complexities.
But bond funds are not bonds.
Unlike bonds, bond funds maintain a constant average maturity, replacing older bonds with newer ones to maintain the fund’s targeted average maturity. This means that when they drop in value as interest rates rise—just like bonds—you can’t hold on until maturity to get your principal back. There is no maturity! So if you bought shares in a bond fund at a high-water mark when rates where unusually low, as they have been recently, once rates rise, it may be a very long time—if ever—before the fund reaches that valuation again.
As part of a total return portfolio, that may be OK, since as rates rise, the bond fund will pay higher interest, so over a year or two, you’ll regain the lost value of the fund from re-invested interest. And if you’re building up your savings, you’ll be buying new shares at a lower price, averaging down your basis—all of which is good for a long-term investor. Meanwhile, the bond fund does yeoman’s double duty, also acting as a dampener to the usual volatility experienced in the equity allocation of the portfolio. In (too) simple terms, when stocks zig, bonds often zag, and overall, you’ll gain more than if you owned just stock funds or just bond funds.
So as part of a balanced investment strategy while building your retirement or other savings, owning bond funds is desirable, even if they get clobbered by rising rates (Ouch!).
But when you are nearing or entering retirement, however, interest rate risk, especially in a low-rate world, can make bond funds too risky to rely on for funding your retirement income floor. It may be time to switch gears. I discuss retirement planning and income alternatives in this blog often, so I won’t digress further now.
The point is that recently when rates spiked and intermediate term bond funds dropped anywhere from 3% to 6% in a matter of weeks, many were caught by surprise. Bonds were supposed to be “safe.” Yikes!
Back to the difference between bonds and bond funds…Bond funds performed pretty much as expected (investment quality bonds, even in funds, are at least predictable)—from historical lows, intermediate and long-term interest rates began to rise, and bond and bond fund values fell to equalize price and yield. An old bond paying less interest than a new bond is worth less—and its price adjusts accordingly. The inverse is also true.
Perhaps over the past decade or two of falling rates and rising bond prices, those who sell securities where a little too zealous pushing their company’s bond funds, with only a cursory mention of the risk that what goes up (bond prices) may also go down when interest rates start to rise again.
In any event, it’s been unheard of, at least in recent times, that bonds could lose money. So the financial products industry is rushing to the rescue of the shocked and dismayed with a slew of new advice and products.
The spiel goes something like this—“Those old “core” bond funds? Well, they’re old-fashioned. You need a new kind of core bond fund, one that can go anywhere, that’s adaptable and unconstrained.”
Adaptable is code for “we’ll time the market for you, shifting deftly in and out of long and short maturities so you won’t get a rising-rate haircut.” Unconstrained means we’re not going to just buy safe investment grade bonds (subject mostly to interest rate risk). Instead we’re going to cut back on the investment grade allocation and add in large dollops of high-yield and floating rate stuff (poor credit!), non-US sovereign and emerging market stuff (currency, political and liquidity risk!), and vary duration, credit and geographic mix to align with the latest headlines (transaction fees and market risk!).
In other words, we’re going to take a good chunk of your old-fashioned investment grade bond allocation and make it a lot more like your equity allocation, subject to a wider variety of risks—more likely to zig along with your stocks when you need that good old-fashioned zag. There will still be some zag, but maybe not so much.
They might make a cursory mention of this increased volatility and correlation to stocks in the footnotes somewhere, but they’re hoping your eyes will bug out at the higher yield. After all, a 6% yield seems like a lot when the 10-year was recently below 2%. Why spoil the pitch mentioning that these higher yielding bonds might fall far lower than investment grade credit when stocks drop in a bear market. Or that rising interest rates mean that investment grade credit is starting to pay higher yields along with lower credit (default) risk…
So there are a growing number of “Go Anywhere Unconstrained Multi-Asset Strategically Tactical Max-Credit Opportunity Funds” out there, beating the drum now that interest rate risk is heating up around the core of investment grade credit. They come with a raft of convincing projections, historical backtests, charts and graphs, and impressive sounding investment theory.
I’m not saying you shouldn’t have international bonds and high-yield in your bond allocation. Just don’t get carried away, and beware the latest financial industry product push. A cocktail shaker full of different kinds of high-yield credit issues won’t skate you past all the dangers we face as the developed world economy continues to deleverage. And keep in mind that bond funds old or new may not be the right retirement income answer for you once you enter the retirement red zone—may not provide consistent, reliable income or maintain a steady value.
By all means, talk to a knowledgeable planner/fiduciary investment advisor who isn’t pushing some new investment product “designed for today’s new economy” and get your overall portfolio allocation tuned up to align with your personal balance sheet, not the day’s headlines. Get a plan and know where you’re going before you “Go Anywhere.”
In the meantime, if you have any questions or comments, please let me know!
–Mike Lonier, RMA℠