In BSW Blog, BSW Philosophy, Economic Outlook, Portfolio Commentary

BSW’s investment group tracks a variety of economic and investment indicators, including key metrics like interest rates, the yield curve, and mutual fund/exchange-traded fund flows.  From that perspective, August has been a remarkable, and portentous, month.

First, the Federal Reserve recently announced it would begin reinvesting principal payments on the $1.3 trillion of mortgage-backed securities it purchased back in mid-2008.  Proceeds from these maturing bonds will be used to purchase US Treasuries, so-called “quantitative easing (QE),” a strategy discussed in the 2nd Quarter 2010 Portfolio Commentary.  The first of these QE purchases, about $2.5 billion worth, occurred today.  The Fed’s announcement, which signaled its concern about the pace of economic recovery, immediately drove bond prices higher and yields lower, with the 10-year Treasury falling to a meager 2.6 percent.

Yield on the 10-Year US Treasury Note

Second, July 2010 marked the 29th consecutive month that retail investors have put more money into bond funds than stock funds.  In fact, more money has gone into bonds in the past two years than went into stocks during the tech bubble in 1999 and 2000!

Finally, and perhaps most ominously, these throngs of retail investors are rushing to the perceived safety of bond funds without a true understanding of the risks involved.  This is evidenced by the 2009 National Financial Capability Study, conducted by the Financial Industry Regulatory Authority (FINRA), which measures the ability of Americans to manage their money and finances.  In that survey, whose results were released early this year, only 1 in 5 retail investors correctly answered the following question:

If interest rates rise, what will typically happen to bond prices?

A. They will rise.

B. They will fall.

C. They will stay the same.

D. There is no relationship between bond prices and the interest rate.

The correct answer is B.  Bond prices and interest rates move INVERSELY.  As interest rates rise, say from 3% to 4%, the value of a 3% bond falls.  Essentially, a bond paying 3% is worth less in a world of 4% interest rates.  The opposite also holds true.  A bond with a 4% interest rate is worth more if general interests fall to, say, 3%.

This concept is critically important in understanding the likely imminent danger faced by recent bond fund investors. Bond funds fluctuate in price daily.  Bond fund investors don’t own individual bonds, but, instead, own shares of the fund, whose price per share is the fund’s net asset value (NAV).  Bond funds pose several risks, but the primary one faced by current bond fund investors relates to timing.  Retail investors who have been pouring into bond funds during the past 29 months are effectively “buying high” and “selling low.”  If and when interest rates begin to rise again, the value of the bonds held in their bond fund will fall – as will the NAV or share price of their bond fund.  Should they need to access capital from the fund (for living expenses or to re-allocate funds to other asset classes), during this time period, they must sell shares of the fund at depressed share price/NAV – locking in potentially large losses.

For these and other reasons, BSW avoids bond funds for our clients’ fixed income allocations and, instead, builds custom, individually laddered bond portfolios. When a BSW investor owns an individual bond, that bond’s yield-to-maturity is determined at purchase and will not change, regardless of bond market or interest rate vacillations.  Further, when that individual bond matures, it will be redeemed for “par value,” generally $1,000 per bond.  Proceeds of shorter-dated maturities in the ladder can then be reinvested at higher interest rates, helping mitigate the impact of rising interest rates and/or inflation.

Unfortunately, many so-called “risk averse” retail bond fund investors, having already been stung by both the tech-bubble and the housing-bubble, appear poised for another rude awakening when the bubble in bond funds also finally pops.  Ouch.

-David Wolf, Chief Investment Officer

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