January 17, 2009

Potential Trap in Bond Funds

Right now with the state of the stock market investing in bonds is looking more and more attractive. If you can get a more dependable get 4-8% return off bonds then that is more attractive to many people than investing in stocks and hoping for a 10% long term annual gain but risking a -20 or -40% short term loss.

An ETF that invests in high yield corporate bonds like the iShares iBoxx $ High Yield Corporate Bd (HYG) can yield about 10% right now. While these are low credit quality rating bonds so the default rate is higher the wide diversification of an ETF and the high yield should make up for the higher defaults. Or you could go with a lower risk and lower yield ETF like the Vanguard Long-Term Bond ETF (BLV) which invests in high quality bonds and yields about 5%.

Say you own 100 shares of BLV today and it trades at $77.79. The yield is 5%. Lets say just for example sake that 12 months from now the average interest rates go up. Lets say at that point that a typical AAA bond will sell with a yield of 6%. If someone can easily buy a bond for 6% then thats what bonds are going to sell at. This means the price of the existing bonds being traded will be less. If you could take $100 and buy a new bond at 6% or you could buy an existing bond at 5% then you wouldn't want to pay the full $100 face value for the 5% bond. That older 5% bond would only be worth about $83 since the return of $5/$83 would equate to a yield of 6%. So if interest rates go up from 5% to 6% then your current bond investment would drop to 83% of what you paid for it. That would mean your BLV could easily drop down to a price of 83% of $77.79 or $64.56.

If the interest rates go up then the price of bond funds will go down.

Given the current situation the interest rates are near or at historic lows. Its very likely that interest rates will go up in the upcoming years. For this reason investment in a bond fund right now could have a built in loss looming in the future.

This is one of the major down sides of investing in bond funds. The price of the bond will go up and down based on changes in prevailing interest rates.

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