There is more to a bond fund than meets the eye. Building a diversified mutual fund portfolio will often require the addition of some type of bond fund. To what degree depends on your risk tolerance, investment objective, and time horizon (how long you intend to be invested). Bonds are typically viewed as a more stable investment when compared to stocks but that isn’t to say they are risk free. Here are two concepts every bond investor should understand.
The duration of a bond mutual fund measures the fund’s sensitivity to changing interest rates. Bond values, in general, change according to prevailing interest rates. If interest rates rise, bond values decline. When interest rates decline, bond values typically rise. The higher the duration of a bond mutual fund, the greater its sensitivity to interest rates. As a rule of thumb, for every 1% change in interest rates, the value of a bond fund will change by the duration of that fund. Let’s assume an intermediate term bond fund has a duration of 4. If interest rates rise by 1%, the value of that fund will decline by 4%. This is often a rude awakening for bond investors looking for lower risk or stable returns.
This very important measure of a bond is the likelihood of default by the bond issuer. Just like not all mortgage applicants are the same credit risk, the same can be said of companies and governments, all of which borrow money. Credit quality has been the domain of agencies like Standard & Poors, Moody’s, and Fitch. These are the major ones and they all have faced much criticism regarding bonds they stamped with AAA ratings that were backed by sub prime mortgages during the housing boom. Despite this debacle, there is still a need to measure credit risks of bond issuers. More importantly, investors need to understand the differences between funds that invest in highly rated bonds versus high yield (a.k.a junk bonds). Many investors get enticed by high yield bond funds and that can have terrible consequences if the intent was to add bonds to reduce risk. Think of credit quality as follows:
1. Higher credit quality equals less risk of default and lower potential return
2. Lower credit quality equals higher risk of default and higher potential return
In general, if you’re trying to reduce risk in your portfolio be careful about adding bonds to the mix. That is not say don’t add bond funds, but be careful of the type. They are not all the same. Don’t be tempted by the term “high yield.” High yield means low credit quality (junk) and higher risk of loss. You should expect bond funds to typically decline in value during periods of rising interest rates and to rise in value during periods of declining interest rates.
Having a basic understanding of duration and credit quality will go a long way toward avoiding costly mistakes.
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