Monday, June 8, 2015

A Warning on Holding Bond Funds

A former owner of a bond trading firm told me over the weekend, "I always knew I was just dealing street drugs."--RW

How Rising Interest Rates Will Crash Your Bond Fund
By Brett Arends

If you have your money invested in bond funds, it’s time to sit up and take notice.

Friday’s strong jobs report has Wall Street penciling in higher interest rates this year and next — and if forecasts are right that could mean some very nasty losses for your bond funds.

According to the financial futures market, Wall Street now expects the Federal Reserve to hike short-term interest rates to 0.75% by the end of this year, 1.5% by the end of 2016, and well above 2% by the summer of 2017.

And Federal Reserve Vice Chairman Stanley Fischer has already warned that within a few years he expects those rates to be back to around 3.25% to 4%.

What would this mean for bonds?

In a nutshell: Bond prices typically fall in a rising interest-rate environment. That’s because a bond guaranteeing you, say, 2% a year for 10 years may be very attractive when short-term deposits only pay 0.25%, like now. But it becomes a lot less attractive when short-term deposits start paying 1%, 2%, or even more. Why would I want a piece of paper guaranteeing me 2% a year for 10 years when I can get 3% in my savings account?

So when short-term rates rise, bond rates have to rise to compete.

And bonds are like a seesaw: When the interest rate rises, the price falls.

How far will your bond funds fall when rates rise? And which bond funds are most vulnerable to rising interest rates?

Finance 101 (again) says the key to your bond fund’s vulnerability lies in a technical measure called the “duration.” It’s measured in months and years, and it’s basically a weighted measure of how long you have to wait to get your money back through coupons and the final repayment of the principal.

The longer the bond, the longer the duration. And the lower the yield, the longer the duration as well.

Read the rest here.

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