Your Assets Can Be In Jeopardy With Bond Funds

 In Bond Investing

bond funds

For roughly the last two decades, it really didn’t matter if you owned individual bonds or U.S. bond funds.

Both delivered consistent returns and a sound hedge against the volatility of the equity market thanks to falling interest rates.

However, that is going to change in the very near future.
Bond Investing Fundamentals

Higher Interest Rates Are on the Way

The writing is on the wall: higher interest rates are coming.

Combine that with the Federal Reserve having completed quantitative easing and you have the perfect environment for a brutal class in the difference between bonds and bond funds.

Don’t be so sure that your financial advisor will be able to save you either. If they’ve ever only been through a bond market rally, this could be an educational shift for them as well.

Bonds vs. Bond Funds

Despite their names, these two types of investments are actually very different. In fact, a lot of professional investors wouldn’t even consider them in the same asset class.

After all, market forces affect bond funds much differently than bonds.

To begin with, individual bonds come with finite maturity.

Whether they’re corporate bonds, municipals or Treasuries, you’re given the date you will receive your principal back, provided the issuer doesn’t default. On that date, your interest payments will stop.

Now, bond funds have a more staggered journey toward maturity.

The manager of the fund replaces them as their issuer calls them, has their credit downgraded or when they mature. This way, they can deliver payments more consistently.

At the same time, you have no set date for when you’ll receive your principal back.

You don’t have a spot on the calendar when you can hope to break even. This could still very well happen, but the certainty just isn’t there.

Advantages of Bond Funds

Bond funds offer a much more diverse portfolio option. This diversity minimizes the reliance on a single security, which means that if a chosen option does poorly, it won’t necessarily affect the overall earnings potential of the entire portfolio.

Many investors in bond funds also find that there is added security in having the portfolio managed by professionals. Bond funds are always managed by SEC-registered investment advisors that have the knowledge needed to know which securities to purchase and when to sell them.

Bond funds also offer greater convenience and flexibility over individual bonds. Investors can change funds within the same managing company, which provides a free rebalancing tool to ensure the best overall potential for earnings within the portfolio.

Bond mutual funds are also more liquid than other options as they must be redeemed at a specified time based on the net asset value (NAV). Any redemption requests must be paid within seven days, providing a much faster means of gaining income when necessary.

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Disadvantages of Bond Funds

While there are many benefits to investing in bond funds, you also need to be aware of the disadvantages.

One of the most important of these is the amount of expenses and fees associated with the overall cost. While the largest of these is the ongoing management fees, the sales and redemption charges and expense fees also add considerably to the cost.

One of the most important of these is the amount of expenses and fees associated with the overall cost. While the largest of these is the ongoing management fees, the sales and redemption charges and expense fees also add considerably to the cost.

A risk is also elevated with bond funds.

The greatest risks come from the fluctuation of the market prices and the potential for interest rates to increase.

Unlike individual bonds, which are purchased at a set interest rate for the term with the principal paid at maturity, bond funds could potentially be in a state of decline for many years, resulting in a significant loss.

The Illusion of Insulation

Many investors mistakenly think that bond funds provide near-complete insulation from market forces.

Unfortunately, rising rates or credit risks can produce a “snowball” effect that quickly drives bond  and bond fund prices lower.

The same thing will happen with bond funds.

When a drop in value occurs, bond funds investors generally become nervous, which, of course, prompts more selling.

Bond fund managers then end up selling some of their holdings in the portfolio off to honor the redemptions they need to pay out. that add more

Bond funds selling would eventually intensify a “snowball” effect

Making the Switch to Individual Bonds

While there are no guarantees in investing, individual bonds may get you as close as possible to a safe haven.

You just want to make sure you stick with the government-backed kind or the highest quality corporate bonds.

However, if you’re portfolio is under $5,000 at the moment, then it might be best to stay with saving accounts or Banks CDs for the moment. Once that changes, then slowly begin switching over to bonds.

Hopefully, you now know the difference between bonds and bond funds.

At the very least, it’s important to understand how the coming changes to our economy will affect them differently so you don’t end up with an unforeseen shock.
Bond Investing Fundamentals

Sergey Sanko
Sergey had started an IncomeClub after years of being an investment advisor for high affluent investors and managing fixed income securities. He is the lead investment advisor representative and holds a Series 65 license. Sergey earned his Executive MBA degree from Antwerp Management School.
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