Written By: Allen Trimble | Secure Money Solutions
For years, many investors have held bond funds as a way to buffer their portfolio from the volatility of the stock market. Ironically, bond funds have provided more of the returns than stock funds, in many portfolios, over the last 12 or 13 years. Now we may be approaching a point where your portfolio needs a buffer from both stock and bond funds! What many folks don’t realize is that we have been in a bull market for bonds for more than 30 years. Despite the inevitable fluctuations along the way, interest rates have been generally declining for 30 years, providing a strong tail wind for bonds and bond funds. As interest rates have been declining, bond values have been rising because interest rates or the yield on a bond move in the opposite direction of its price.
Does the bond fund you’re holding as a way to buffer your portfolio from the risk of stocks, actually contain more risk than you think? These funds could in fact contain sticks of dynamite. Why? Because you can’t hold a bond fund until maturity, there is no maturity date on a bond fund. Right now interest rates are so low. They have only been this low three percent of the time that U.S. treasuries have existed. So the odds of them increasing are very high, and if that happens many of these bond funds will suffer significant losses, as much as 20%, 30%, 40% declines in value. So the idea that your bond fund is safe is really misleading.
Not only that, more than ever bond funds are investing in stocks, which could expose investors to volatility they don’t know about. Understanding the dynamics of the bond market (the relationship between interest rates and bond values) many bond managers have taken advantage of their ability in most cases to invest up to 20% in stocks. The Wall Street Journal reports that the number of bond funds that own stocks has surged to the highest point in 18 years, with 352 mutual funds classified as bond funds holding stocks according to Morningstar. And a third possibly misleading aspect of bond funds is that bond fund managers that are investing in stocks are comparing their performance to the bond funds that really do contain all bonds. So they’re bragging about their performance, but they’re investing in apples and oranges while they’re beating a benchmark that is just investing in apples.
What is the solution? While there is no one-size fits all for any investment or savings strategy, a good place to start is to determine the purpose of the money that is currently invested in bond funds. Is it purely as a volatility buffer for stocks? Or is it a ‘conservative growth’ option? Is it for income? Or as is often the case, are those bond funds there because…. they always have been? If you are looking for a buffer to the stock market, perhaps a good solution would be to look for an actively managed strategy for the stocks or stock funds themselves; there are many tactical strategies that have proven their worth over time. Or you may want to consider a fixed or fixed indexed annuity which many people think of as a ‘bond alternative’ (NOT variable annuities; they own stock and bond fund-like ‘subaccounts’ within the annuity). Fixed or Indexed annuities can also be a good fit if you are looking for conservative growth. With these products you are buying a fixed rate of interest, or linking your interest gains to the stock market, giving up some growth potential in return for downside protection. They offer reasonable returns without risk. Be sure to be aware of MVAs or “Market Value Adjustments” or you could end up with similar risk to principal that rising interest rates cause in bond funds. Annuities also require a time commitment; they are partially liquid so you may pay a penalty to withdraw more than 10% of the value each year. Which infers income, or at least liquidity. Annuities are the only financial product that can guarantee income for life (subject to the claims-paying ability of the insurance carrier). For income planning, today’s annuities can create high levels of income and still allow you to control the principal should you need that flexibility in the future.
Of course, the bond funds that you own may still serve your needs. But it might be wise to look things over, just to make sure they don’t go ‘BOOM!’
About the Author: Allen Trimble is founder of Secure Money Solutions (SMS) with a mission to serve retirees and soon-to-be-retirees by helping them to create mathematically correct retirement income solutions so that they can enjoy secure, sustainable income for life with growth for the future. Feel free to contact Allen directly at (210) 293-1893 if you have any questions. Also, you can learn more by visiting his website at www.safemoneytexas.net.