In a harsh lesson, investors have recently learned that the safest of bonds become vulnerable when interest rates rise. U.S. Treasury bond funds, TIP funds and municipal bond funds have delivered sharp losses in the past two months.
Bonds have been destroying savings in college funds, 401(k) funds, IRAs and retirement nest eggs.
To add insult to injury, the bonds that are considered the safest have inflicted the most damage. Individuals lost 6.24 percent of their money last quarter in mutual funds that invest in U.S. government bonds that don't mature for several years. In just two months, investors lost more than 7 percent in funds that invest in government bonds geared to cut the impact of inflation, or Treasury Inflation-Protected bonds, known as TIPs. Municipal bonds were roughed up too.
“Bond market performance has fallen off a cliff since early May,” said Morningstar analyst Christine Benz.
Ned Davis Research strategist Joseph Kalish called the devastation “bloodletting.”
Analysts are worried that investors who see bond losses in account statements will think there is something wrong with their particular bond or bond fund and bolt.
But while some bond fund managers might have maneuvered through the bond storm with more finesse than others, most bond funds are suffering losses.
And that is to be expected. Bond funds, after all, invest in bonds. So when there is essentially no place to hide in the bond market, a bond fund will have losses. About the only place to escape the carnage has been in bond funds that invest in bank loans. Yet many cautious investors would have avoided such funds because those loans are riskier than U.S. Treasury bonds.
In tough economic times, borrowers from banks might have trouble paying back their loans. So if you are like a lot of people, you might think your money in a U.S. government bond fund would be safer than in a bank loan fund.
But bond investors are learning a key point about safety in these harsh times. There are two types of risk in bonds. One is known as “credit risk,” which you see in the bank loan funds. They pose the risk that you could lose your money if businesses run into financial trouble and can't pay back the bank.
Another risk is “interest rate risk.” That's the risk hitting bonds that people typically consider completely safe — bonds like U.S. Treasury bonds and inflation-protected bonds. Interest rate risk hits and makes those safe bonds dangerous when interest rates start climbing. Last quarter, one of those periods hit with force.
The yields on U.S. Treasury bonds that mature in 10 years shot up sharply from 1.6 percent to 2.5 percent in about six weeks. That might not seem like a lot, but in the quiet world of bond investing, that's huge. The fear that it would keep happening caused the pros to sell bonds rather than getting stuck with them. Consequently, the typical U.S. government bond fund got whacked.
If you are holding a single 10-year Treasury bond, rather than a bond fund, you have lost money on paper too.
But that loss is different from the losses people experience in U.S. Treasury bond funds. If you have an individual U.S. Treasury bond and hold on to it until it matures, you will keep getting your interest payments, and, at the end of the holding period, you will get your principal back too.
Bond funds are a different animal, and can actually inflict losses, because there is no date when it matures. If you hold on to the fund for many years, you may not detect the losses you see in your account now. But if in a few months, you need to pull money out of your bond fund for living expenses, your losses will be real.
Why would Treasury bonds in a bond fund become losers? Until recently, some bonds were yielding just 1.6 percent.
But then came the interest rate spurt, and suddenly yields jumped to 2.6 percent.
If you had a choice between earning 1.6 percent or 2.6 percent, you'd want the extra percentage point. So investors shun the bonds that paid 1.6 percent, and those bonds become losers. With your bond fund full of them, you are losing now too.
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