Most investors don’t realize bonds can be highly volatile, even government bonds.  I’m not referring to the risk of default either, I’m specifically referring to principal loss in the event of rising interest rates.

Since bonds pay a state coupon rate, as interest rates in the economy change bonds already issued face valuation adjustments.  Here’s how it works

• Buy a 5 year treasury bond today at 1.71%, and you get $17 a year in interest, plus your $1,000 back in 5 years
• Two years from now a NEW bond investor can get a 3% coupon (hypothetically of course, I don’t have a crystal ball)  = $30/year
• The new investor get’s almost twice the yield as your bond
• Your bond on the open market now must be discounted – or a principal adjustment – in order to make it even with new bonds
• That markdown has to be roughly equivalent to what new bonds are paying (plus other factors beyond this discussion)
• For the next three years, an investor buying your bond needs to make up $13 ($30 – $17) in lost income per year, that’s $39 or 3.9% of the bond value for the rest of the life of the bond
• A new investor might pay you roughly 96.1% of par value for your bond, or $961 dollars to compensate for the lost income
• Your bond, if you sold today, would be worth about 4% less than what you paid for it
• You must hold to maturity to get the original $1,000 principal back.

That was a very crude example and it’s more complicated.  There’s bond convexity, duration, and other market speculation factors that control the open market for an already issued bond.  But the example is a reasonable illustration.

The same holds true with bond mutual funds, except it can be far worse because there is no finite maturity date – the bonds just roll over and over at the managers discretion.

This is solely a discussion on interest rates in the economy, not default speculation.

If interest rates go up, your bond mutual funds will go down.  The longer the maturity (more specifically the duration) of your bond mutual funds the more it will drop.  It’s that simple.

I’ve said for a couple years now I see a large problem for investors – specifically retirees – who chase yield in bond mutual funds.  The more aggressive you get trying to increase your investment income, the more risk you have to your principle.  If you’re going to be aggressive with bonds why not own stocks?

Retirees specifically face a huge problem if they’re living on a fixed income.  Many retirees have little to no stock exposure and prefer the lower volatility of bonds and bond mutual funds.  But with interest rates at historic lows at what cost?  Stocks will likely far outperform bonds over the next decade (stocks have doubled the return of bonds over the long term), and the real risk to investors is inflation (erosion of purchasing power) – not short term volatility.

I often say in my private practice that my core concern is ensuring my retired clients can buy the same gallon of milk today at 4$ when it costs $10 in 20 years!  Or mail an envelope in 30 years when they’re 90 and a stamp costs $1.50 (the math works out, and remember a stamp was just .15 in 1980!).

Bonds – while less volatile than stocks – aren’t safe!  They fluctuate as well.  You can experience principle loss with bond mutual funds just as you can with stock mutual funds.

The only prudent course of action is to build a diversified portfolio, one that is well rounded and pegged properly to your personal risk profile.  Rather than focus on specific asset classes or mutual funds, focus on the foundation of your investment plan – the asset allocation.

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