The Risks of Bonds and Bond Funds
For investors who are trying to decide between an investment in individual bonds or bond funds, there are several important considerations.
One allure of fixed income investing is that in the case of most individual bonds, investors can be assured that they will receive their principal back upon the bond’s maturity. There are only a few instances where return of principal is guaranteed: U.S. Treasuries and other bonds backed by the U.S. government. Other types of bonds – such as municipal bonds,investment-grade corporate issues, and high-yield bonds – offer no such guarantee, but even in these cases the historical rates of default have been modest. This is particularly true among issues with the highest credit ratings. So does this mean that investors can also invest in a bond mutual fund and expect to receive all of their principal back?
The answer to this question is a simple “no,” which unfortunately can take some investors by surprise. Like stock mutual funds, bond funds invest in a portfolio of numerous individual securities. Each night, the fund companies assess the value of the securities in each of their funds and calculate their net asset values, or NAVs. Since each of their individual bond investments can be traded on a daily basis just like a stock, their prices can fluctuate based on market forces. As a result, the prices of bond funds will move up and down along with the value of the securities they hold in their portfolios.
Consequently, an ill-timed purchase can mean that an investor will have to sell the fund at a lower share price than they originally paid. Sometimes this is made up for by the income generated by the fund, but not always.
The risk, and magnitude, of principal fluctuations depends on the type of fund you own. Some funds only invest in highly-rated, short-term bonds, and in these cases the share price may prove relatively stable over time. Other funds, particularly those that take a more aggressive approach and/or invest in higher-risk securities such as high-yield bonds, can experience substantial share price fluctuations. In 2008, for example, the fallout from the financial crisis caused many high-yield bonds portfolios to lose between 30-40% of their value. Funds that invest in emerging-markets debt are also among the most volatile options within fixed income.
The bottom line: if principal stability is your primary concern, be sure that the investment you choose corresponds with your objective. Sometimes, a mutual fund won’t fit the bill. And if you decide to invest via a mutual fund, carefully examine the share price history to ensure that you can stomach the volatility.