Bond 'Losses' Got You Down? Ask Yourself These 4 Questions

Includes: AGG, HYG, IEF, JNK, LQD
by: The Financial Lexicon

As yields have marched upward in recent months, there have been a lot of stories about bond portfolio "losses." I think it is important to distinguish between the unrealized losses from a bond fund vs. those of an individual bond. When owning a bond fund, with the exception of a defined-maturity fund, you cannot be certain that you will avoid notable future losses if the price declines after your purchase. When owning an individual bond, however, absent a default by the issuer, you can be certain that the price of the bond will mature at par.

That said, I understand that major movements in bond prices, especially at the long end of the curve, can make some investors uneasy. This might even be true for individual bond investors. In "Providing Perspective On Your Bond 'Losses'," I outlined four questions that I think individual bond investors should ask themselves should the unrealized mark-to-market declines in their bonds make them feel a bit uneasy. Those questions are:

  1. Has the issuer of any of your bonds defaulted on its debt obligations?
  2. Is the issuer of any of your bonds in danger of defaulting on its debt obligations in the foreseeable future?
  3. Will the bonds that are causing you uneasiness mature at par?
  4. In the foreseeable future, do you anticipate being forced to sell any of your bonds in order to raise cash?

If you answer the questions as follows: 1) No, 2) No, 3) Yes, and 4) No, you should be able to rest easy. Take a long-term perspective on your holdings that are, absent a default, destined to mature at 100 cents on the dollar, and ignore the daily unrealized mark-to-market movements.

In light of the Fed's two-day meeting this week, at which it is widely expected that tapering of QE will begin, you should expect some decent volatility in benchmark Treasury yields (NYSEARCA:IEF). If at any point the volatility in bond prices makes you feel uncomfortable, remember the four questions outlined above. Should your bond allocation be mostly in non-defined-maturity bond funds, however, make sure you are well aware of your fund's duration. Duration measures the sensitivity of a bond or bond fund to changes in interest rates. For simplicity's sake, what you need to know about duration is that you can generally take a certain percentage point change in interest rates and multiply it by the duration of your bond fund to determine how much your fund might move. For example, if a fund's duration is four years and interest rates move higher by one percentage point, the rise in interest rates would lead to an estimated 4% decline in the price of your bond fund. So what's the duration of some of the more popular bond ETFs?

Concerning high-yield bond funds, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) and the SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK) both maintain constant durations generally between four and five years. The interesting thing about these funds is that should benchmark Treasury yields rise because of an improving economy, you will likely see high yield corporate bond spreads decline further from today's levels. This means that some or perhaps even all of the rise in Treasury yields would be offset by spread contraction, and the price of the fund might not decline in price. On the flip side, should investors perceive worsening business conditions for companies with "junk" debt ratings, spreads would widen. In such an environment, you would also likely see Treasury yields fall. Despite falling Treasury yields and rising benchmark prices, it is entirely possible that your high-yield bond fund would fall in price.

On the investment grade side, the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD) has a bit longer of a duration, in the seven to eight years range. It consists entirely of corporate bonds, with a huge concentration in the A1/A+ to Baa2/BBB credit-rating range (Moody's and S&P ratings). While that part of the ratings spectrum would also experience spread contraction and spread widening depending on the economic environment, the changes in spreads would not have as large an offsetting effect on the price of the fund as changes in high-yield spreads have on HYG and JNK.

The iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG) is another example of an investment-grade-focused bond fund. Its effective duration is in the five- to six-year range. From a duration and credit spreads perspective, what makes this investment-grade-focused fund different from LQD is that it has a major allocation to Treasuries and mortgage-backed securities (36.33% and 28.64%, respectively). It also has smaller allocations to agency securities, commercial mortgage-backed securities, and sovereign bonds. Regarding this fund's price, changes in corporate bond spreads will play a much smaller role than they do in the aforementioned bond funds.

There are countless other bond funds that you might own. If the potential for future volatility in bond prices has you concerned, remember to check the duration of your fund as well as the fund's holdings. In some cases, just because benchmark bond yields may head higher doesn't necessarily mean that the prices of the underlying securities in your fund's portfolio will head much lower. Sometimes, spread contraction can have a major offsetting effect. And for individual bond investors, the next time you are feeling a bit uneasy about the mark-to-market changes in your holding-to-maturity portfolio of bonds, remember to ask yourself the four questions outlined above. Sometimes investing can be as much an emotional challenge as it is a security selection challenge.

Disclosure: I am long numerous individual bonds. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.