The Risks of Buying U.S. Treasury Bond Funds
Interest-Rates / US Bonds Sep 28, 2010 - 08:10 AM GMTBy: Nilus_Mattive
A number of us here at Weiss have been warning you about the dangers of buying bonds in this ultra-low-interest-rate environment, especially longer-dated U.S. Treasuries.
But as I recently told my Dad’s Income Portfolio subscribers, I think mainstream investors are still ignoring the risks they’re taking with bonds, particularly when it comes to fixed-income mutual funds and exchange-traded funds.
And this topic is so important that I want to explore it a little more today with you. After all …
Investors Have Been Snapping Up Bond Funds at a Record Pace Lately
According to the Investment Company Institute, investors were net sellers of stock market mutual funds in the first seven months of this year, withdrawing more than $30 billion.
At the same time, they plowed a net $273 billion just into taxable bond funds!
Now, as I’ve told you before in these pages, there are myriad problems with allocating a large portion of new money to bonds in this environment:
First, you are essentially locking in historically low interest rates.
Second, your bond’s yield has zero chance of ever going up.
Third, if interest rates rise or the investment herd suddenly sours on bonds for some other reason, you can experience capital losses, too!
Meanwhile, there are dividend-paying shares out there that can hand you higher yields right now … continue raising their payments over time … and hold up well even if the broad stock market declines.
Of course, a common response from bond bulls is that as long as they hold their Treasuries until maturity, and unless the U.S. government defaults on its debt, they cannot experience losses at all.
That’s true. And I understand that some folks may be comfortable earning just 2 percent or 3 percent a year for the next decade given what’s happened in the markets over the last few years.
Heck, I see nothing wrong with allocating some of your portfolio to high-quality individual bonds, even today.
But I Also Must Point Out that Bond Funds Do Not Offer You the Same Protection of Principal!
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Before I go any further, let me say that the rise of mutual funds and exchange-traded funds has been terrific for individual investors.
I think bond funds can be a great way to play individual categories of the fixed-income markets, too.
But I also want you to understand that these funds entail serious risks, especially right now.
Reason: Mutual funds and ETFs do not typically hold bonds to maturity. Quite the contrary — they are actively buying and selling their holdings.
What this means is that anyone investing in a bond fund — even if it’s strictly allocated to “safe” government bonds — can experience substantial losses.
According to research done by Wharton professor Jeremy Siegel:
- If, over the next year, interest rates on the 10-year Treasury go back up from a recent level of 2.47 percent to 3.99 percent (where they were last April), bondholders would lose 9 percent …
- If rates went to 5.83 percent, where they were before the Great Recession began, the loss would grow to 15.8 percent …
- And on 30-year Treasuries, just a jump from the recent level of 3.52 percent to their average level over the last three decades (7.3 percent) would produce a loss of 50 percent!
By the way, these figures include any interest paid by the bonds over the one-year period.
Now, am I saying that fund owners would experience this same level of losses? No.
Nor am I saying that interest rates will hit the levels mentioned above anytime soon. Based on the Federal Reserve’s latest meeting, low interest rates will be here to stay for quite a while longer.
Still, I think you need to be very careful with the bond portion of our portfolio.
Whether you’re buying individual bonds or broad-based funds, do your homework and realize that very few options are completely risk-free — especially at a time like this, when investors are eagerly snapping up nearly any kind of debt Wall Street rolls out.
Best wishes,
Nilus
P.S. My recently-updated retirement guide has an entire section devoted to building a better bond portfolio, including strategies to lessen the risks I discussed above. For more details on that, just click here now.
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