9 Bond Fund Risks To Evaluate

10-Year Yields last year

Now that’s price volatility! Government Agencies, Exchanges, Major Bond Investors, and Main Street Investors are again preparing for the long awaited upward shift in interest-rates and a potential collapse in bond market prices and liquidity. Deja Vu, right? Know your risk exposures and understand the location of your hard earned dollars!

The thought of bond market liquidity evaporating or double-digit drops in bond investments is unnerving enough; however, I am especially concerned where investors are exposed to two trends often seen in 401(k) plans, 529 College Savings Plans, Target Date Funds (TDF), and certain other ‘glidepath’ robotic advice formulas: 1) massive use of bond funds and exchange-traded funds (ETFs) in lieu of direct bond ownership and, 2) traditional advice of raising allocations to bonds as investors age or move closer to goal dates. As an illustration of size, Vanguard expects TDF adoption to hit 50 percent in 2015 and reach 63 percent of the 3.9 million participants enrolled in Vanguard-administered plans by 2018.

Fun Fact: Outstanding U.S. bond market debt
has grown from $31.7 trillion in 2007 to
$39.2 trillion in 1Q 2015. Source: SIFMA

No wise Advisor can assign certainty to the proximity nor consequences of this highly anticipated change in U.S. monetary policy. There are plenty of reasons to believe a Federal Reserve driven rate increase may be postponed beyond 2015due to deflationary forces such as weak global growth and employment, instability in Europe, Middle East, and Asia, shifting demographics, and the exponential price destabilizing impact of technology. However, Fed Chair Yellen seems determined to continue a stated gradual path to “normalcy,” and any move away from the 0-0.25% range in the Fed Funds target will be highly symbolic.

Suitable bond mutual funds and ETFs used in isolation or in combination with individual bond strategies can be very effective. Still, financial market participants may collectively induce higher interest-rate risks, so take heed of nine not-so-obvious risks to evaluate in your bond exposures.

  1. The “Bond” label is not always synonymous with conservatism or lower risk. For illustrative purposes, the opening graphic plots daily percent yields for the “risk-free” U.S. 10-Year Bond from 6/19/2014 to 6/19/2015. Price movement in this key benchmark rate is likely to experience historic volatility in the future. Other segments (high yield, municipal, emerging, mortgages) of the massive bond market are smaller and less liquid than Treasuries.
  2. Principal, maturity, and credit features are not guaranteed or insured–Many investors do not realize, understand or appreciate that bond funds can fall in price. Bond funds are not insured or guaranteed by FDIC, the U.S. Securities Investor Protection Corporation (SIPC), or by any other government agency, regardless of underlying holdings, or how a bond fund is purchased or sold—whether through a brokerage firm, bank, insurance agency, financial planning firm, registered investment advisor or directly.
  3. A net asset value (NAV) of fund shares is no guarantee. An ability to sell fund shares on any business day does not translate into the characteristics of “liquidity” in the sense of price and bid protection for underlying holdings. Funds make assumptions in their daily pricing matrices and actual future sales (especially forced) of holdings can receive prices much lower than modeled assumptions. Note: Closed-end bond funds trade at premium and discounts to underlying NAVs.
  4. Embedded leverage–The proverbial double-edged sword. Funds use yield enhancement strategies to try and boost returns and market their portfolios to attract or maintain investor dollars. This activity can translate into less obvious risks and the use of reverse repos, commitment agreements, and exposure to floating-rate credit lines with banks or bank syndicates should be noted too.
  5. Is the Fund 100% committed to owning actual bonds? Whether due to Fund size or purposeful strategy, additional counter-party and contract liquidity risks are introduced with the use of synthetic positions. Derivative contracts may also involve implied or economic leverage.
  6. Date & Data Matching on Fund Report Cards. Always check the “As of” date on top holdings, risk metrics, returns, credit weightings, and asset breakdowns. Look closely, and you may see inconsistency with the published report issue date–Are you sure you know what you own?
  7. Speaking of Holdings. Among other reasons, unprecedented low rates and high prices have forced some fund managers to reach for yield outside stated comfort zones or core competencies. For example, “conservative” funds with heavy exposures to potentially high risk Puerto Rico and Tobacco bonds.
  8. Metric Effectiveness. Listed durations are very popular and convenient numeric gauges of interest-rate sensitivity. Unfortunately, these generic stand-alone descriptions of price sensitivity can mislead investors due to straight-forward assumptions and limitations. Realized prices and actual market bid adjustments always trump mathematically derived estimates. Any assumed downside needs to consider the size of yield changes, yield volatility, and the new shape of the yield-curve. Most bond funds consist of hundreds or even thousands of bonds across a spectrum of maturities, sectors, credits, and bond features–so accurately portraying a full portfolio’s risk is more complex.
  9. Historical “average” returns, dispersion of said returns, and the degree of like movement with other assets should not be extrapolated. The chart below shows a clear example of unprecedented U.S. Central Bank activity beginning in 2008; whereby, the Federal Reserve increased the size of its balance sheet five‐fold from $900 billion to $4.5 trillion. Translation: Objects as seen in the seven year rear-view mirror are very distorted.

Key Rate Factor: Federal Reserve Activity

On June 17th, the FOMC reiterated that “The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.”  In March 2015, 15 of 17 FOMC participants judged that the first increase in the target federal funds rate (now 0-0.25%) would occur in 2015 even though the same contributors expect inflation to be well below the 2% target with a central tendency at 0.6% to 0.8% in 2015.

Key Rate Factor: Inflation Expectations

Below is a representative graph of the Fed’s preferred inflation gauge, PCE Inflation—as measured by the percent change in the personal consumption expenditures (PCE) price index is headed downward. Graph retrieved from FRED, the excellent resource at the Federal Reserve Bank of St. Louis: https://research.stlouisfed.org/

It has been more than a decade since the Federal Reserve raised interest rates and nearly seven years since the fed funds rate was set near zero. Still not a forgone conclusion that a new rate regime starts in 2015, government agencies, exchanges, major bond investors, and private investors are again preparing for significant changes. So join them in preparing your mind and portfolios.

A choice not to lose can be a winning strategy, and prudent portfolio management always considers potential reward units versus potential risk units. Each investor and their trusted advisors should follow a continuous wealth management process of Discovery & Diagnostics, Planning, Implementation, and Supervision. As you work through the review steps, note that the “bond” label is not always synonymous with conservatism, low risk, or stability. Please evaluate your obvious and not-so-obvious risk exposures to bond funds and exchange-traded funds.

I welcome your thoughts in the comments section below. 

ABOUT THE AUTHOR:

Michael loves to empower investors with his expertise in securities and economic analysis, goals-based wealth management solutions, and FinTech smart decision-support tools. He has directly managed over $5 billion in growth and retirement assets, and his proactive advice has influenced thousands of fiduciary advisors to better their practices and service to clients. He enjoys spending time with his wife and three boys, competing in USTA tennis, and mentoring others to succeed.

Email l mdhakerem@gmail.com
Twitter | @MichaelHakerem

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