Investors constantly hear encouragement to place their savings in the stock market. Even with the 401k at work, employees will receive memos from management telling them to take more risk with their retirement savings so as to outpace future inflation. The average investor does not like the stock market since he views it as a casino and could wipe out most of his assets. Then, the financial crisis hit in 2008.
People watched their stock investments fall some 60% in value during 2008 and early 2009. Unfortunately, many investors withdrew their funds from the stock market and watched while the market recovered over the following 2 years. Where did they put their assets?
Most of the assets at the time went into money market mutual funds and bank savings accounts for safety, but earning a very low amount of interest. Since interest rates stayed at record lows, these investors then started putting moving their money into longer term bond funds in an effort to earn a higher level of interest. Essentially, bond mutual funds of all types became, and continue to be, the most popular investment in town. The average individual investor still has not, returned to the stock market due to the losses experienced in 2008.
General Types of Bond Mutual Funds
There are two factors that determine the objective of a bond mutual fund.
- Category of bond investment – The categories of bonds are determined by the type of debtor. Essentially a bond is an IOU by an entity to an investor. If a person buys a US Savings bond, the debtor is the US Government. The major categories of bonds are US Treasury bonds, corporate bonds, Municipal bonds, foreign bonds (usually governments. The reason investors
- Average maturity of the bonds – The funds will be short term (1-5 year bonds), medium term funds (5-15 year) or long term (15-30 year). The longer the average term of the bond fund, the greater the risk, and, in turn, the higher the interest earned.
The combination of the bond category and average maturity will determine the overall level of risk in the portfolio. A Short term mutual fund investing in US Treasury bonds would be extremely safe, though yield the least amount of interest. Conversely, a long term mutual fund investing in municipal bonds may be risky since many municipalities are rapidly going broke. There may be a risk of default for some of the bond holdings. However, this fund would yield a higher level of interest vs. a US Treasury fund.
Issue Facing Bond Mutual Fund Investors
Market Interest rates are still very low historically, and bond prices are high. Eventually, inflation and other negative factors will push market interest rates up, and so bond prices will fall (interest rates and bond prices move in opposite directions). When this happens, the prices of the bonds held in bond mutual funds will fall. Shareholders wanting to withdraw assets from the fund will experience a loss of principle.
How Bond Mutual Fund Shareholders Can Protect Against Severe Losses
Participants in bond mutual funds should thoroughly analyze fund information to ascertain exactly what type of bonds and the average length of maturity of the fund holdings. The investors’ objective, given the current economy, should be to have their assets in shorter term maturity funds, and the safest fund from a credit risk viewpoint. Funds that meet this objective are short or medium term mutual funds that invest in US Treasury bonds. Investors should rebalance their portfolios while prices are high.
Rebalancing the portfolio to shorter term bond mutual funds will cause the investor to earn less interest. However, the risk of eventual principal loss with longer term bond funds is steadily rising. Safety of bond principal should be the first concern.