Beware of bond funds

Investment Analysis Clubs Macro Economic Trends and Risks
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Investors are often advised to buy shares in bond funds to balance the risk of stocks. Defined date funds also hold bond funds.

In a free economy, bond values often move in the opposite direction of stocks. Portfolio managers recommend a balance of stocks and bonds to moderate volatility.

For the past 10 years or more, Federal Reserve monetary pumping caused stock and bond prices to rise at the same time. (Bond prices rise when interest rates fall.) The free market is still not operating since the central banks are moving massively in the bond markets.

The Federal Reserve and the Bank of England are both raising interest rates.

https://www.marketwatch.com/story/10-year-treasury-yield-edg…

**Treasury yields move higher as Bank of England delivers second hike, ECB’s Lagarde sees upside inflation risks**
**By Vivien Lou Chen and William Watts, Marketwatch, Feb. 3, 2022**

**Treasury yields were broadly higher today after the Bank of England delivered its second consecutive rate increase and European Central Bank President Christine Lagarde said inflation risks in the eurozone are “tilted to the upside” relative to December....**

**The European Central Bank stood pat and affirmed the path for winding down pandemic-related asset purchases that it laid out in December. Lagarde, the ECB’s president, said there was “unanimous concern” among policy makers about inflation at Thursday’s policy meeting, and policy makers would make a more detailed assessment of the impact of higher-than-expected inflation in March...** [end quote]

Money flows internationally to find the highest yields. When the Bank of England raises rates, demand for U.S. Treasuries is lower so the yield rises.

https://stockcharts.com/freecharts/candleglance.html?$IRX,$U…

Unlike individual bonds, which can be held to maturity to get the par value, bond funds do not have a set maturity. The Net Asset Value (NAV) of a bond fund constantly fluctuates as the manager trades bonds and bonds mature to be replaced with other bonds at a market rate. In a rising interest rate environment, the NAV will fall. The capital loss will not come back as long as rates stay higher. The yield of the bond fund will gradually rise as fresh bonds are added, eventually yielding the prevailing interest rate at the when the duration of the fun is reached. This is less for short term bond funds, more for long term bond funds.

This is not a good time to be buying bonds. Especially beware of bond funds.

The same rises in interest rates will hurt stock prices, especially companies with a lot of short-term debt that must be rolled over at higher rates.

The only type of bond whose value does not fall when interest rates rise is the I-Series Savings Bond, which is not marketable. Even TIPS values fall as interest rates rise.

Wendy

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In addition, the net asset value (NAV) of a bond fund is expected to decline as interest rates rise. This causes some share owners to sell. That in turn can force the bond fund to raise cash by selling bonds. Panic selling can force sales at the worst possible time causing further declines in NAV.

Buying individual bonds and holding to maturity is a far better strategy. The market value of the bonds can decline with rising interest rates but that only matters if you sell them. When held to maturity, you still receive full face value (unless the company defaults. A good reason to buy investment grade bonds.)

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Buying individual bonds and holding to maturity is a far better strategy.

Yes, when you buy bonds and hold them till maturity, you can more closely estimate how much your loss is in real terms. Basically, it’s roughly the yield minus inflation, which is now estimated to be negative for nearly all government bonds, and even negative for many corporates. But when you buy bond funds, there is no way to determine how much you will lose, because that depends on others (if they sell shares in the fund, the fund manager has to sell bonds at a loss, perhaps not only the yield minus inflation loss, but also a [permanent] capital loss by selling the bond under par).

I’m not sure what retirees are doing with their bond portion nowadays. If you have a 60/40 portfolio, that’s a LOT of fixed income you need to find! The only bonds I own right now are I-bonds (with real returns between 0 and 3.4%).

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Hi Wendy,

I was hoping to get your thoughts on this. Would you recommend getting into bond funds/ ETFs now?

The talking heads in CNBC seem to quote high yields upto even 8% for investment grade bonds but search as I might, I don’t see that…I see something close to that on high yield, but “junk” bonds…the name freaks me out!

Also, are these yields reliable…for example, if I buy a VWEHX, it seems to quote 7.45% current yield and 7.9% yield to maturity…so, if I buy it today and keep it for say 5 years and then sell, will I get 7.9% per annum as yields PLUS my original deposit?

Or will the NAV value and the yields of the bond funds that I buy today change according to the whims and fantasies of the stock/bond market, and the yields also change depending on the interest rate hikes…meaning neither the principal or the yield is guaranteed at the end of 5 years.

Once again, thanks for taking the time to teach.
Charlie

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@Inspired2learn you ask good questions.

When I discuss bonds, I usually talk about Treasuries, which have no default risk. That is a “pure” discussion of interest rates. Every Treasury bond is exactly like every other Treasury bond, except for their duration.

Corporate bonds are not like Treasury bonds. Every corporate bond is different. Every company is different. A company may have layers of debt where some creditors are paid first and others are paid out of whatever is left over (subordinated debt).

“High yield” bonds are called “junk” bonds for a reason. These are bonds that are rated CCC or below by Moody’s and/or S&P. Even the best says, “Obligations rated Caa are judged to be of poor standing and are subject to very high credit risk.” This is a zombie company.

In plain English, that means, “This company has barely enough cash flow to pay the interest on this bond at the best of times. If anything changes for the worse – if sales fall or if it has to pay higher interest on other debt that it is rolling over, it’s likely to run out of money to pay the interest on THIS bond.”

Junk bonds act more like stocks than they do like Treasuries. Yes, corporate borrowing rates rise when Treasury rates rise. But, in addition, corporate borrowing rates rise when the market anticipates a recession because sales will drop and zombies may default.

Investors in junk bond funds have to judge two parameters.

  1. Will prevailing interest rates rise? That will put pressure on companies that will have to roll over maturing debt.
    For example, let’s say a zombie company issued a 5 year bond at 10% in 2017. Now it’s 2022 and that bond matured. But they can’t afford to pay back the money they borrowed out of cash flow. They could barely make the interest payments! So they will have to borrow again to pay off the principal of the 2017 bond. (That is called “rolling over” the debt.) Look at the chart. OOPS! Now the rate is almost 17%!

  2. What is happening in the economy? Will the business continue to make good sales and cash flow so they can pay their interest? If a recession is coming, zombie companies may default and may even declare bankruptcy.

A junk bond fund has many bonds. They expect some of them to default. The question is whether the high yield from the ones that continue to pay more than covers the defaulters.

Is this a good time to invest in VWEHX, Vanguard’s high-yield bond fund? First, let’s look at the fund.

https://advisors.vanguard.com/investments/products/vwehx/vanguard-high-yield-corporate-fund-investor-shares#overview

I like their investment approach. “Fundamental credit selection process.” That means they scrutinize each bond separately to see if the company is likely to pay the interest. “Higher credit quality and lower return volatility relative to competitors.” I like that a lot. “Broadly diversified by issuer and industry sector.” That’s good, because a recession that hurts one sector may not hurt a different sector as badly.

Morningstar gives VWEHX four stars.

The YTD return is -10%. Bond funds are different than individual bonds because the fund does not have a maturity date like a a bond. Only the NAV matters. Interest payments are used to buy new shares at current prices so you dollar cost average. If you need money, you sell some shares.

Could the NAV of VWEHX go lower in the near and medium term future?

Yes.

The Federal Reserve has been transparent that they intend to raise the fed funds rate. That guarantees that criterion 1 – prevailing interest rates – will push down the NAV.

Criterion 2 – the economy – is also looking bad. A recession is likely in 2023. This may push many zombies over the edge. Defaults may be higher than expected.

I think that VWEHX may be an excellent junk bond fund. But I think that this is the wrong time to buy it. As a risk-averse investor, I wouldn’t buy a junk bond fund until AFTER the recession, when sales are recovering and the zombies have been washed out by the recession.
Wendy

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Rising interest rates mean the bonds in the bond fund fall in value to keep their yields up with market rates. Hence your NAV is expected to decline as interest rates rise. Better to buy the bonds themselves and hold to maturity. Then you receive full face value (unless the company goes bankrupt).

Investment grade bonds are rated BBB or better. Some say even BBB is risky. Junk bonds are lower rated and that means the bond rating agency could not find assets to repay the bond at maturity. Whatever the bond was issued for must succeed and make profits if the holder is to be paid at maturity. And of course they can suspend interest payments along the way in tough times. And that is likely to get them into bankruptcy court.

The one good thing about bond funds (and etfs) is you have pros selecting the bonds. They should be able to avoid buying bonds of failing companies–most of the time, but not always.

Junk bonds are risky especially when a recession may be coming. Quality is worth the price.

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I agree with this when buying Treasuries or highly-rated corporate bonds. But I think it’s almost impossible for an individual investor to accurately gauge the risk of a single junk bond from the scanty information available. Better to leave this to the pros in a bond fund…if the investor wants to take the risk of investing in junk bonds at all.

I agree with you about quality.
Wendy

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Thanks so much Wendy and Pauleckler!