What Bond and Bond Fund Investors Need to Know Now

Tuesday, January 1, 2013

The outlook for traditional bonds and bond funds doesn’t look great with historically low yields today, and perhaps even lower yields and values on the horizon. 

“Our concern today is that people are putting a lot of money into traditional bond funds, seeing the income that these bond funds produce,” says Jim Bernard, CFA, senior vice president and director of fixed income portfolio management, as well as an investment advisor representative at Ancora Advisors LLC. 

However, that income is already falling and Bernard says it is going to continue to drop significantly. 

“On top of that, the net asset values of these funds will be falling as the bonds they hold move closer to maturity because values today, in many cases, are significantly higher than the face value at which the bonds will pay off,” he says.

Smart Business spoke with Bernard about how the bond market works and what that means for investors’ portfolios.

 

How does the traditional bond market work?

Bonds are continuously traded based on two things: the risk of the investment and the current interest rate environment. Currently, the likelihood of credit defaults is low for both corporate and government bonds. However, if a company has a history of losing money, you will want to pay a lower price for that bond or demand a higher interest rate in order to offset the risk of not getting your money back at maturity. 
 
Interest rates and bond prices have an inverse relationship — as interest rates go down, bond prices go up. If you own a bond that pays a stated interest rate of 5 percent, due in three years, it would currently be worth more than face value to an investor because bonds maturing in three years are currently only paying 2 percent.

 

What do low interest rates and falling bond yields mean for investors?

Interest rates are low and have been for almost five years. They will likely stay this way for another two to five years. So the challenge is deciding whether investors should buy bonds that pay low rates of interest or put money in other places — the stock market, commodities, gold, real estate, etc. 
 
If you bought a 15-year bond 10 years ago when interest rates were 5 percent or more, you might be happy. Unfortunately, most people tend to invest in bonds maturing within five years or sooner, and that means their bond holdings are at historically low yields.

 

What is the difference between owning an individual

bond and a bond fund?

With individual bonds, you get the face value of your bonds back at the maturity date or call date, barring a default. In a bond fund, because it is perpetual, you never know what the future value will be. 
 
Most investment advisers would prefer people invest in individual bonds if they have enough money to adequately diversify
simply because of the added comfort of knowing what your bonds will be worth at maturity. 
 
If you do not have enough capital to adequately diversify, or are in an instrument such as a 401(k), where individual bonds are unavailable, you may have to invest in bond funds if you want fixed-income exposure. You then must decide whether you are more concerned about the value of your fund or the income it produces.

 

What can we expect from bond funds in the future,

and what should investors in bond funds do now?

Most individuals invest in bond funds in order to receive income, but that income has dropped dramatically as interest rates have fallen. For instance, one intermediate-term corporate bond fund has paid an average dividend yield of 5.4 percent over the past 12 months, but the current yield has already dropped to 3.3 percent. With five-year government bonds currently yielding 0.63 percent, is it not likely that the current 3.3 percent yield will be maintained.
 
The second reason an investor would buy a bond fund is for the net asset value of the fund. The net asset value of a bond fund typically only goes up when interest rates go down, but can interest rates go much lower, and therefore can bond prices go much higher? And even if interest rates stay flat, the net asset value will decrease as bonds within the bond fund get closer to maturity since the majority of bond prices are currently above face value.
 
So in general, concerning traditional bonds and bond funds, this is not a great time to be in either. If you have owned bonds or a bond fund for many years, you may be comfortable. However, for new money or money from maturing or called bonds, there are other, more attractive sectors
with bond-like returns that are not as tied to interest rates. These include:
 
  • Master limited partnerships, which pay a rate of interest through the infrastructure of the U.S. energy system, pipelines, etc.
  •  Certain real estate investment trusts, where income is derived from real estate projects.
  • Certain sovereign bonds, which are non-U.S. government bonds and offer a way to diversify from the U.S. dollar.
  • Merger arbitrage funds, which have bond return characteristics but are invested in equities.
 
If your bonds are still paying a good rate of interest, there is no need to be too concerned about selling as long as you are confident you are going to get your money back at maturity. However, right now may not be a good time to allocate new investments to the bond market. 
 
 
JIM BERNARD, CFA, is senior vice president and director of fixed income portfolio management as well as an investment advisor representative
at Ancora Advisors LLC, an SEC-registered investment adviser. He is also a registered representative and a registered principal at Ancora Securities, Inc., member FINRA/SIPC. Reach him at (216) 593-5063 or jb@ancora.net.