FINRA Sounds The Alarm For Bond Funds

by: George Fisher

This is a follow-up to an article published on SA last Dec concerning interest rate risks of bonds and bond funds, and the concept of duration.

The Financial Industry Regulatory Authority (FINRA) sounded the alarm for bond investors, especially long maturity bondholders. In an article published Feb 14, FINRA offered this statement: "outstanding bonds, particularly those with a low interest rate and high duration may experience significant price drops." More information on FINRA can be found here.

If you own bonds or have money in a bond fund, there is a number you should know. It is called duration. Although stated in years, duration is not simply a measure of time. Instead, duration signals how much the price of your bond investment is likely to fluctuate when there is an up or down movement in interest rates. The higher the duration number, the more sensitive your bond investment will be to changes in interest rates.

The higher a bond's duration, the greater its sensitivity to interest rates changes. This means fluctuations in price, whether positive or negative, will be more pronounced. If you hold a bond to maturity, you can expect to receive the par (or face) value of the bond when your principal is repaid, unless the company goes bankrupt or otherwise fails to pay. If you sell before maturity, the price you receive will be affected by the prevailing interest rates and duration. For instance, if interest rates were to rise by two percent from today's low levels, a medium investment grade corporate bond (BBB, Baa rated or similar) with a duration of 8.4 (10-year maturity, 3.5 percent coupon) could lose 15 percent of its market value. A similar investment grade bond with a duration of 14.5 (30-year maturity, 4.5 percent coupon) might experience a loss in value of 26 percent.1 The higher level of loss for the longer-term bond happens because its duration number is higher, making it react more dramatically to interest rate changes.

Duration has the same effect on bond funds. For example, a bond fund with 10-year duration will decrease in value by 10 percent if interest rates rise one percent. On the other hand, the bond fund will increase in value by 10 percent if interest rates fall one percent. If a fund's duration is two years, then a one percent rise in interest rates will result in a two percent decline in the bond fund's value. A two percent increase in the bond's fund value would follow if interest rates fall by one percent.

According to an article recently published in the Weekend Edition of the Wall Street Journal that also looked at the risk of bonds. The article suggested methods to manage interest rate risk of:

  • Keep duration short
  • Review emerging markets
  • Consider adjustable rate leverage loan funds
  • Build bond ladders

Specific bond funds and ETFs mentioned in the WSJ article include:

Vanguard Short-term Bond ETF (NYSEARCA:BSV) with a duration of 2.7 years, fees of 0.11% and a 1.6% yield

iShares 1-3 Treasury Bond ETF (NYSEARCA:SHY) with a duration of 1.7 years, fees of 0.15% and a 0.4% yield

PowerShares Emerging Market Sovereign Debt ETF (NYSEARCA:PCY) with a duration of 9.1 years, fees of 0.5% and a 4.6% yield

iShares Emerging Market Corporate ETF (BATS:CEMB)with a duration of 5.5 years, fees of 0.75% and a yield of 4.2%

PowerShares Senior Loan Portfolio (NYSEARCA:BKLN) with fees of 0.75% and a yield of4.8%

Guggenheim Date Specific 2017 Corporate Bond ETF (NYSEARCA:BSCH) with a duration of 4.2 years, fees of 0.24% and a yield of 2.5%

iShares Date Specific 2016 AMT-Free Muni Bond ETF (MUAE) with a duration of 3.2 years, fees of 0.3% and a yield of 1.4%.

Bond investors need to balance current yield versus the risk to principal, especially in bond funds with longer maturities and higher durations. It is not uncommon for 30-year Treasury bond funds to have durations of 20+ years, or in other words, for every 1% rise in long bond rates, these funds could lose upwards of 20%+ of value.

Bond investors also need to weigh in on current yield versus inflation expectations. If inflation clocks in at 2.5%, short bond ETF SHY may offer some protection from rising rates, but also offer a negative real rate of current income.

While some may say bonds funds will lose money only when sold, protection of principal for that inevitability should be front and center.

My preference is to develop a ladder of Guggenheim Date Specific Bond ETFs with both corporate and high yield exposure. In addition, while current income may be negative in real terms, short treasuries are added to mix to reduce credit risk.

The whole concept of this approach is to protect principal to fight another day when bond income yields are stacked more in investors favor. Heeding FINRA's warning should begin by reading and understanding their recent investor alert.

Author's Note: Please review important disclaimer in author's profile.

Disclosure: I am long BSCH. 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.