Big Risks in Bonds and Bond Funds

Vanguard published a quick guide to the theoretical losses on short, medium and semi-long term bond funds that would occur with 1% and 2% bumps in interest rates.

The dollar is plummeting against foreign currencies and trillions in stimulus money have yet to be reflected in inflation figures. Vanguard’s 1 – 2% projected rate increases may prove way too mild. Even so, here are the figures they published…

Vanguard defines

• Short-Term Bond Funds as: 2.6 years average duration
• Total Bond Market Funds as: 4.4 years average duration
• Long-Term Bond Funds as: 12.1 years average duration

By definition, longer term bonds (like 30-year Treasuries) would show much bigger losses than the table below lists for average durations up to just 12.1 years.

Fund Category	Price Drop on 1% Rate Rise	Price drop on 2% Rate Rise
Short-Term Bond Fund	(-2.6%)	(-5.1%)
Total Bond Market Fund	(-4.5%)	(-9.4%)
Long-Term Bond Fund	(-11.0%)	(-19.9%)

Risk-averse investors should be very wary of any fixed income vehicles with more than one year maturities.

Comments

[ndallasj:]

Your point is well taken. I am sticking with my short term bond funds, however, for several reasons:
1) The yield is more than 300bp higher than money market funds;
2) Since I am reinvesting dividends, I will, in effect, be dollar cost averaging as the NAV declines when interest rates rise;
3) Because of their short term-nature, the funds themselves will be buying, on average, about 3% new instruments each month to replace lower-yielding ones that roll off, thereby increasing yield;

The main risk that concerns me is that investors in the funds I hold will panic and sell their holdings, thus forcing the funds to liquidate at the wrong time and limiting their ability to add new, higher yieding securities to their porfolio.

Oct 11 10:17 AM

[Fund Insider:]

Depends on your purpose for FI investments.
Older retirees in nearly 100% bonds should heed this warning.
If you are less than 60 years old, just using FI as part of overall
asset allocation, remember that the hedging effect of bonds is greater with longer term bonds than shorter. When equity markets decline, your short term bonds wont rally that much, maybe a bit.
Just as difficult to predict interest rates as the stock market, so
buy a mixture of long and short term bonds for diversification, and be prepared to have a bumpier ride on the longer term bonds.

Oct 12 09:50 AM

[SPOTS:]

The only bonds I own now are foreign, (both developed and emerging market). I am particularly comfortable with foreign inflation protected bonds (WIP). You are safe from inflation and gain principle as the dollar drops. I am short long U.S. treasuries and looking to go much farther short in the near future.

Oct 12 11:41 AM

[Plant the s...:]

Any sharp rise in interest rates from rising inflation will indeed hit long bonds. The risk is mainly sitting in the long bonds, especially government bonds with ultra low current rates.

ndallasj: did make a great point that if you reinvest the earnings this may less problematic and with shorter duration funds the roll off and new investments will allow for buying higher interest rate bonds.

I think retirees depending on the income for their expenses are going to see the biggest impact, versus active investors who can reinvest dividends.

Oct 12 05:10 PM

[User 214486:]

Anyone have a link to the actually vanguard article/study? Would be greatly appreciated.

Nov 13 11:33 AM