Some Factual Perspective for Bond Fund Investors

BondsTim Buckley succeeded Gus Sauter as Vanguard’s chief investment officer over a year ago. Among various topics touched on during an introductory interview, the comments of Mr. Buckley on the challenges facing bond investors back then are worth repeating now:

“Bonds … are an area of concern for us [Vanguard]. … At the same time, we’ll tell you not to abandon bonds. They serve a great diversifying purpose in a portfolio. When the equity markets zig, it’s the bond markets that can zag. The other bit about bonds is that as rates go up, yes you may have principal loss [of value], but you’ll be reinvesting at a higher rate. If you stick with the portfolio, you can be better off over the long term.”

In recent months, we have been subjected ad nauseam to scary headlines about bond “massacres,” “crashes,” and “panics.” In this environment, investors need to remember that the dreaded “L” word, as in loss, only kicks in if bond investors sell, thereby suffering a “realized” loss. Otherwise, the loss in value is an “unrealized” loss, or “paper loss,” as reflected in an account statement.

In a New York Times article, “Tremors From the Fed’s Grand Experiment,” financial columnist Jeff Summer provided this insight:

“None of this [market’s volatility] looks very reassuring right now, yet in the long run, rising bond yields and an end to the Fed’s unconventional policies [quantitative easing of the money supply] could be very good news. After all, yields have been so low mainly because the economy has been weak. A continued climb in rates … would presumably reflect market participants’ belief that the economy was strong enough to withstand higher rates.”

If you are a long-term, buy-and-hold investor in bond mutual funds, it’s assumed that this position is the result of a rational asset-allocation decision. Your bond holdings, which are less risky than your stocks, provide balance, i.e., safety, to your overall portfolio.

Additionally, the fixed-income from these holdings is either reinvested to strengthen your bond position or paid out to be used, most likely, as retirement income. The key to surviving a bond bear market is to hold investment grade bonds with intermediate-term durations. The interest rate sensitivity of a bond, its “duration,” is expressed in years.

For example, Dodge & Cox Income [DODIX] is a Morningstar Gold Analyst Rated intermediate-term bond fund. Its portfolio has a medium investment-grade [BBB] credit-quality rating and a reasonable average duration of 3.7 years. How would this fund’s principal value fare in a rising interest rate environment?

As a rule of thumb, analysts gauge the potential loss of bond value by multiplying a bond’s duration by the percentage increase in the ten-year Treasury bond interest rate. Let’s say, for the sake of discussion, that the rate increase is 2%. Using our rule of thumb, DODIX’s potential loss in portfolio value would be 7.40% [3.7 years x 2%]. With an average SEC bond yield of 3.15% [est.], the net decline in value would be 4.25% [-7.40 +3.15%].

This loss of value is modest, and will be transitory, as the bond fund’s portfolio of lower yielding holdings mature, are called, and/or traded and replaced with bonds carrying higher yields. In this scenario, the patient bond investor stays with an investment-grade bond portfolio that progressively captures increasingly competitive rates of return.

Richard Loth is the founder and publisher of the Fund Investor’s Schoolhouse, a mutual fund investing educational platform for individual investors (www.fundschoolhouse.org).

Copyright © Richard Loth 2014 ? Fund Investor’s Schoolhouse™

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