A common misconception among many investors is that, "Bond mutual funds are safe." Investors can understandably confuse the term "fixed income" with prices that do not fluctuate. However, fixed income investments can depreciate in value and this may be especially true for many bond mutual funds. When interest rates go up, current bond prices and bond mutual funds may go down in value as fixed income values typically have an inverse relationship to interest rate moves. Interest rates have been generally declining for about the last 40 years in the US and there could be a secular shift taking place. The Federal Reserve has already raised rates six times this cycle and hinted they will continue to do so. The rate on the ten year government bond is up 28% this year alone. What does this mean for bond investors? Here are the 2018 returns of a few fixed income investments through May 23rd , 2018.
MUB - Municipal Bond ETF: -1.9%
MBB - Mortgage Backed ETF: - 2.8%
AGG - Aggregate Bond ETF: -3.3%
LQD - Investment Grade Corporate Bond ETF: - 5.5%
TLT- 20 Year Government Bond ETF: - 7%
XLU – Utilities ETF: -5.3%
Source: Thomson One.
The past decade has seen rates decline substantially in the US. As this happened, many bond mutual funds gave investors not only interest income but also appreciation. This may have given many the false impression that bond funds always give positive returns. This is not the case. Investors should not be lulled into complacency by the perceived safety of bonds and especially of bond mutual funds.
There are strategies to reduce interest rate risk in a fixed income portfolio. Purchasing individual bonds over bond funds is one way. While bond prices may go down, owning individual bonds provides a specific date at which the bond matures and pays face value, regardless of interest rates. Another way to reduce fixed income portfolio risk in a rising rate environment is to shorten maturities and the overall duration of the portfolio. This is easier to do with individual bonds in one’s own portfolio, as investors have no control over bond mutual funds. If bond mutual funds must be used, in a rising rate environment the prudent investor would seek mutual funds with short durations, or even negative durations. There are alsocertain asset classes that may tend to move directionally with interest rates. These are some of the strategies that we are currently helping clients to implement.
Senior Financial Advisor
Total Wealth Planning and Management, Inc.