Risk, Returns, and Regret in Bond Investing

“It’s a conundrum.” This is what ex-Federal Reserve Chairman Alan Greenspan said of the state of long-term interest rates. The situation that exists—with short-term rates getting measured increases, while long-term rates haven’t moved much—is a topic of confusion for many people, not just Greenspan.

Now we are concerned with another conundrum: Principal guarantees within bond investments.

A new client of ours whom we will call Bob is retired, and relies heavily on a fixed-income. Recently, while rebalancing his investment portfolio, he expressed confusion over the status of certain bond funds that he has held for years. Bob told us he heard from a former colleague that his principal might not be guaranteed, even though he had invested in government-bond funds, which he assumed were safe. Now we had the difficult job of explaining to Bob that perhaps he had become tangled in a common misconception — that government bond mutual funds do not guarantee principal. Furthermore, income distributions that such bond funds provide are both inconsistent and unpredictable.

Government bonds and government bond trusts are principal guaranteed. But investing in bond funds is not done on the same terms. While an individual bond pays the owner a consistent amount on each coupon date, there is nothing “consistent” about a bond fund, and distribution depends entirely on how well each of the bonds within the fund fare. At any given distribution date, the amount of money received can vary greatly. Therefore it is not even appropriate to label a bond mutual fund a fixed-income product.

This means a lot to Bob, because he and his wife depend on a predictable number of dollars at consistent intervals throughout the year. If that income doesn’t come in as anticipated, his lifestyle can be affected dramatically.

We’ve seen misunderstanding of bond-fund investments perpetuate itself over the years. The reason why mutual funds do not guarantee principal is because they are open-ended. Shares are offered continuously, and have no maturity date. If there’s no maturity, there’s no date for principal repayment. Hence, no principal guarantee. Conversely, government treasury bonds, bills, and notes, and government-bond trusts do have a finite life, or a fixed maturity date. When these bonds mature, the principal is repaid. Hence, a guarantee of principal.

Let’s look at a specific example. When Bob spends $10,000 on 10-year government treasury bonds at 5-percent yield, he will receive $500 dollars of fixed income annually, and is guaranteed every dime of his initial principal at maturity — 10 years from the date of issue. These bond investments are backed by the full faith and taxing power of the United States federal government. If, on the other hand, Bob buys into a mutual-bond fund, even though the bonds in the fund are government treasury bonds, the fund itself has no maturity date. And there is no exception to this rule. The same system applies to corporate, municipal, and “junk” bonds; the issuing institution backs those bonds and the rating is determined by the institution’s ability to pay.

Bottom line: We are not trying to turn people completely off from investing in bond mutual funds. There are some appropriate uses (and we stress the word some) for bond mutual fund investments. The key is to understand what you’re doing. The potential risk and rewards need to be weighed so that no matter what the outcome of the investment, feelings of regret (from not being properly informed) won’t seep into the equation. If, like Bob, you are on a fixed income and therefore require a predictable and continuous stream of income throughout your retirement years, we urge you not to panic; but rather to review your portfolio and seek advice from a financial professional.

December 30th, 2008 | Comments Off on Risk, Returns, and Regret in Bond Investing

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