Low Interest Rates and Bond Mutual Funds

changes-signAll we’ve know for the last decade or so is low interest rates but are they really a good thing?  While they are great when taking out a mortgage what are they doing to your investments?

During a recent conversation with my husband, who invests for a living, we were discussion bond mutual funds and the dramatic effect that will occur to these investments when interest rates start to rise.

I thought the information he shared would be  helpful to others so I asked him to do a little write up explaining bond mutual funds, because everyone thinks bonds are a safe investment and that might not be the case.  Here is his explanation:

The Perils of Bond Funds in a Rising Interest Rate Environment

Individual investors have been flocking into bond mutual funds for the perceived safety and protection of fixed income securities.  A cumbersome reality is that the value of a bond drops as interest rates increase; simply put, if you own a bond paying 2% and interest rates rise to a point where an identical bond is issued at 5% – your bond has to be worth less in the eyes of any rational investor.

If an investor purchases an individual bond such as: 3.625% Walmart 07/08/2020 (maturity) they could wait until the 2020 maturity date and receive all of their principal (initial investment) back.   The problem is that most investors don’t purchase individual bond holdings in their portfolio for many good reasons such as lack of diversification, trading costs and insufficient knowledge in trading bonds.  The investment industry has made it easier for the individual investor by creating bond mutual funds but with the ease comes risk.

Most bond fund investors don’t realize that it’s unlikely they will get their exact initial investment back due to what is known as Net Asset Value (NAV).  In bond funds, there can be hundreds, if not thousands of bonds in the portfolio.  An investor buys into the bond fund at the Net Asset Value (NAV), of the fund and owns a slice of all the bonds in the portfolio.  As interest rates rise, and if the fund continues to keep the same bonds in the portfolio, the value of the bonds in the portfolio will decline, as will the NAV.

With interest rates sitting at generational lows, investors are forced into buying bonds at inflated prices and if they are purchasing bond funds, the NAV prices are also inflated.  As interest rates normalize, both bond prices and bond mutual fund NAV prices will drop in tandem – leaving bond fund investors with significant principal losses that they will never be able to recover.  Conservative bond fund investors looking for income and safety are unknowingly buying significant risk and won’t know it until it’s too late.