“We still see good flows into intermediate-term and nontraditional bond funds so far this year,” said Morningstar analyst Kenneth Oshodi. (Investors pulled more than $16 billion from high-yield bond funds in the first two months of this year.) “It’s high-yield debt [fund flows] that have suffered most with the volatility.”
For the first time in a very long time, it appears that interest rates are headed higher. Inflation remains below the Federal Reserve’s target of 2 percent, but it is rising and there is growing expectation that it will soon become something more to fight than to hope for. The Fed seems convinced. Last month it raised rates a quarter point, to the range of 1.50 percent to 1.75 percent, and is telegraphing at least two more rate hikes this year.
While 10-year bond prices have recovered slightly from their fall early this year, most analysts expect the 10-year yield to continue moving higher and to finish the year above 3 percent.
“We think rates may finally march upward from here,” said David Yeske, co-founder of investment advisory firm Yeske Buie.
That’s bad for bonds and bad for bond funds — though not in exactly the same way.
The growing popularity of bond funds for investors is due to the simple fact that they are the simplest, cheapest way for investors to buy a diversified basket of bonds. Investors can buy the broad market of government and corporate bonds, they can target international fixed-income markets, or they can invest in slices of the market or sectors therein. Bond funds offer a degree of diversification that only large scale can bring.
“We think it’s imperative to be diversified with bonds if you want more than just Treasurys,” said Yeske. “Bond funds can give you a globally diversified portfolio at a low cost.”
Yeske currently has his clients’ bond allocations parked in funds with a duration of only one year, and he never stretches beyond three to five years’ average duration. “Our view of the role of bonds is as a stable reserve of value,” he said. “We’re looking for low volatility.”
Financial advisors, however, do have issues with the bond fund as an investment vehicle. Unlike individual bonds, funds do not have a maturity date. The pool of bonds mature at different times, and the net asset value of the fund reflects the value of all the securities holdings. The buyer of an individual bond simply can buy and hold it, and absent a default, receive their fixed interest payments and the return of their investment at maturity.
Bond funds hold no such guarantees. Income will vary depending on market conditions, and there is no promise that you’ll receive your initial investment back when you sell. In an extended environment of rising rates and falling NAVs for bond funds, investors could suffer capital losses if they have to sell the investment.
“With funds, you don’t own the bonds,” said Jon Yankee, CEO of FJY Financial. “You own shares of a mutual fund. “There are thousands of decision-makers involved, and if they pull money from the fund, you can be affected negatively,” he added.