Bond Funds Look Safe Until Rates Start Rising

Generally accepted financial planning guidelines always recommend that a portion (typically 40%) of an investor’s portfolio be in bonds. Very few buy individual bonds, meaning this allocation will likely be in bond funds. There are some problems and risks to your wealth from a large allocation to a bond fund.

First, a bond primer:

A bond is defined by its par, or face value, as well as its coupon rate and maturity date. With the maturity date and coupon (amount of interest paid) rate fixed, bonds adjust to changing interest rates by becoming pricier or cheaper. Bond prices and yields are inversely related. When yields go up, bond values fall, and vice-versa

If you buy a bond and hold it until maturity, you will earn the yield-to-maturity in effect at the time of your purchase.

Bond funds, mutual funds, and ETFs follow the same effects from changing interest rates. When rates rise, bond fund share prices fall. The problem with bond funds is that they do not hold bonds until maturity. A typical fund is managed to a specified average maturity. From my experience, this structure causes bond funds to decline when interest rates rise, and they can never recover all the losses when rates then rise.

This chart from Charlie Bilello’s The Week in Charts email caught my eye. 

The chart shows bond return drawdowns (negative returns) and how long it took to recover to the original investment value. The longest drawdown in history began in August 2020, and the bond index is almost back to break-even. That’s 5.5 years (67 months) of negative returns on bond investments if the investment was made in mid-2020.

I have long recommended against purchasing bond funds as a large portion of an investment portfolio. In the best case, it’s dead money; in the worst case, bond funds can experience significant drawdowns.

However, I have recommended specific bond funds as an equal-weight position in a portfolio. I look for uniquely managed funds with a stronger possibility of generating attractive returns. Currently, I recommend the Infrastructure Capital Bond Income ETF (BNDS). This actively managed fund yields 7.9% and has exhibited positive share price gains.