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Bond funds are similar to stock mutual funds in that they are pooled investments under the control of a fund manager who makes investment decisions. The most significant difference between the two is that a bond fund contains a selection of bonds, rather than stocks.
Bond funds are marketed as being a great way to achieve instant portfolio diversification and provide either active management for a fee or performance that matches a particular bond index for a much smaller fee. They can also help safeguard against the volatility of the stock market without subtracting too much from the portfolio.
However, bond funds are far from perfect, and there are potential risks and strategic disadvantages that you may want to consider before adding them to your retirement plan.
Bonds Can Become Leveraged Under Aggressive Management
Actively managed bond funds can, under the direction of more aggressive managers, leverage their returns by using derivatives, and borrowed money to multiply returns. A leveraged bond fund with $200 million in assets from investors might borrow another $300 million against existing shareholder capital. The fund would then use that borrowed money to purchase more bonds on behalf of its investors.
There is then the potential to triple gains. Unfortunately, a 3% drop in bond value in a 3x leveraged bond fund could also produce a 9% loss. Basic risk management indicates that it is almost always a bad idea for those in or near retirement to own leveraged bond funds.
Interest Rate Risk
Just as is the case with individual bonds, bond funds are highly reactive to prevailing interest rates. When interest rates rise, bond prices must fall so that they remain competitive with new bonds issued at higher interest rates. Lower interest rates, on the other hand, boost the prices of bonds. The only way around this is to find a fund family that offers bond funds with “floating” rates. Even then, the fund will not be immune to fluctuations in the interest rates.
Fees Can Be High
Depending on the individual mutual fund company, the degree of active management, and the specialization of the fund, fees for bond funds can be high. Many international bond funds, for example, tend to have higher expenses which are passed along to investors. If you are considering a bond fund, you will need to understand all the fees involved and how they will impact your investment.
There May Be Barriers to Redemption or Purchase
A popular bond fund that you would like to own may be closed to new investors at the discretion of the fund manager. Usually, this occurs when the manager believes that purchasing additional bonds could potentially dilute the quality of the portfolio. Other bond funds, especially those favoring institutional investors, may set the investment thresholds so high that average investors can’t afford to participate. It’s not unusual to see thresholds of $100,000 and up for certain funds. Some bond funds may also charge redemption fees if you sell your shares within a certain period (ex: 60 or 90 days).
No Control Over Your Investment
Since most bond funds are actively managed, the bonds selected by the fund are chosen by the manager and not by the investors themselves. I am sure you are aware, leads to difficulties when a manager makes unwise choices for the fund. Also, in a bond fund, you do not choose the interest rate you receive from investing. This is significant because it affects the total amount of your interest payments. Additionally, there could be tax consequences for you should the bond fund manager sell off some bonds for a profit.
Unpredictable Risk Levels
In contrast to owning individual bonds, bond fund risk can fluctuate as underlying assets change due to the manager’s decisions. The fund might decide to invest in bonds that you think are too risky or too conservative. If a fund manager shifts the fund’s focus to buy more long-term bonds, the fund will have increased exposure to interest rate risk. Finally, every bond issuer has terms, so interest payments you receive can change every time assets in a fund are bought and sold.
Lack of Maturity Date
Since bonds are considered to be long-term investments, most investors purchase them with a view toward holding until maturity. When you invest in individual bonds, the issuer agrees to return your principal when the bonds reach maturity. A bond fund, on the other hand, does not offer this feature. Managers of bond funds are continually trading, often selling bonds before they reach maturity. When you own a bond fund, you never have a time when you are assured of getting back 100% of the money you put in.
Credit risk refers to the risk that issuers of bonds owned by a bond fund might fail to pay the debt they owe on the bonds they have issued. This is known as “default,” and while the risk tends to be much lower for funds investing in US Government bonds, there are funds that choose to invest in bonds of issuers with lower credit ratings.
Bond Funds Can and DO Lose Money
Many people believe that owning bonds or bond funds insulates them from market risks, such as prepayment, credit, and interest rate risks. But this is not the case.
The Security and Exchange Commission’s website states, “A common misconception among some investors is that bonds and bond funds have little or no risk. Like any investment, bond funds are subject to several risks…”
Should You Consider Bond Funds?
Bond funds may have a place in the portfolios of some individuals. However, they are not without risks and disadvantages that should be carefully considered before making a decision. This is especially true for those who are entering the pre-retirement and retirement phases of their lives. Those wanting a safer and less stressful post-work life simply cannot risk losing any money.
Since so many safer alternatives exist, it may not make sense for pre-retirees and retirees to include bond funds in their portfolios. In any case, consulting with a trusted financial planner who has your best interests in mind is always a great idea.
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