The Risk Of Bond Funds In A Rising Rate Environment

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Includes: BIL, CLTL, DFVL, DFVS, DLBL, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, FTT, GBIL, GOVT, GSY, HYDD, IEF, IEI, ITE, PLW, PST, RISE, SCHO, SCHR, SHV, SHY, SPTL, SPTS, TAPR, TBF, TBT, TBX, TBZ, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UST, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: Financial Sense

By FS Staff

The following is a summary of our recent Lifetime Income Series broadcast, which can be accessed on our site here or on iTunes here.

Despite strong gains among bond funds over the past decade, Jim Puplava warns this trend may be about to end.

From 2009 to 2013, investors poured $1.5 trillion into bond funds in response to the Fed axing rates down to zero; as a result, Baby Boomers looking for high yield retirement investment vehicles - especially those lacking pensions - fled government-backed bonds and switched over to bond funds.

"If you're retired and all you have to live on is social security or whatever you had in your 401(k) program, people began to use bond funds like they were CDs - because it was the only place left," Puplava said.

Investors have no idea of the amount of risk they are taking in the bond markets, because the last bond bear market ended in August 1981.

"All Boomers have experienced in the last three decades is falling interest rates. They have no idea what a bear market for bond funds looks like," Puplava said.

What creates a bond bear market? Puplava listed some major factors:

  1. Bond funds may buy lower-quality bonds (junk bonds for example) instead of AAA or investment grade bonds - a strategy that can be especially risky during a recession.
  2. Some bond funds may invest in bonds that use leverage - i.e., bonds may be undergirded by illiquid assets. When it comes time to pay the piper (liquidation of the bond), investors in such funds may not be able to withdraw their investment in a timely manner.

Since the Fed's rate raising cycle is just getting warmed up, Puplava warns that bond-fund fueled retirement portfolios may get slammed. That kind of bear attack will be especially hard on Baby Boomers who will be ready to retire over the next few decades.

Because everyone has been searching for better yields in this low rate environment we've been in since the economic recovery began eight years ago, people are stretching for higher yields, leading the SEC to implement new disclosure rules regarding bond funds.

The SEC now requires bond funds to disclose categories of liquidity for the bonds they hold; in other words, investors must be informed as to how many days in which the bonds must be liquidated. There are six categories: 1-3 days, 4-7 days, 8-15 days, 16-30 days, or 30-plus days. Such specific timetables may scuttle value if they sell the bonds at a loss to meet their category deadline.

Puplava warns that most bond fund investors have no idea how risky some funds may be due to these and other economic factors: "Investors must learn how to manage money differently in a rising rate cycle and a looming bond-fund bear market."

He recommends that investors get a thorough financial evaluation to determine needs, risk factors, and, especially, how investment strategies may impact an impending retirement. Bond fund investors should not be dazzled by higher yields, but rather, deploy a healthy skepticism when investigating such funds.

He added that the Fed has stated another rate hike is likely in May or June or at the end of the year - a move which will likely sink the bond fund market for the long haul.

"You have to really understand that not all bond funds are created equal. If you're getting that high rate of return, you'd better understand why it is you're getting that... and what's going to happen to you if rates continue to rise."