Fixed income is supposed to be a conservative strategy for generating income.
And if you do it right – by owning some individual bonds – you’ll be just fine. You can even make a profit in addition to your income if you buy the bonds cheaply.[ad#Google Adsense 336×280-IA]But bond funds aren’t the same as individual bonds.
And that’s why, starting this week, I’m purging bond funds from my personal portfolio.
When interest rates go higher, bond prices head lower. If you own an individual bond and are planning to hold it until maturity, it doesn’t matter. Here’s why…
Let’s say you buy a bond for par, or $100. (The actual cost is $1,000. If you bought it at $99, you’d pay $990.) The bond pays a 5% yield.
Each year, you’ll collect $50 in interest. It doesn’t matter what direction rates or the price of the bond go, you’ll still get that $50.
However, the price of the bond will fluctuate. If rates spike higher, the price of your bond will fall.
But that matters only if you’re selling the bond. If you hold it to maturity, you’ll receive the par value or your $1,000 back. And if you bought it for $990, you’ll make a $10 profit.
Bond funds work differently. Bond funds have individual bonds in them, but the fund doesn’t mature. So you’re not going to get your money back if rates rise and bond prices fall.
Bond funds trade bonds and often don’t hold them until maturity. For example, the Fidelity Total Bond Fund (FTBFX), a $25.7 billion fund given a gold rating by Morningstar, has a turnover ratio of 134%.
That means it buys and sells its entire portfolio more than once a year. In other words, it’s trading bonds, not investing and holding them.
If rates go up, those bonds will be sold at a loss.
Fidelity isn’t the only one. The average turnover ratio for all bond mutual funds is 97%. So the average bond fund turns over its entire portfolio once a year.
You are practically guaranteed to lose money.
It’s Trump’s Fault
If President Trump is able to enact his pro-growth polices of corporate tax cuts, cash repatriation, deregulation and infrastructure spending, they should act as stimuli to the economy, pushing inflation and rates higher.
And to butcher Michelle Obama’s “When they go low, we go high” quote… When rates go high, bonds go low.
Bond funds have been a decent place to be for a long time in the low-rate environment. Many paid a decent yield. And as rates were falling over the last 30 years, those funds performed well.
But the days of ultralow rates look like they’re over. The Fed isn’t artificially keeping rates pinned to the floor, and an expanding economy has already moved rates higher – and should continue to do so for the foreseeable future.
Because I have many years to go before I retire, my portfolio is mostly in stocks – but I do own a small amount of bond funds as well as individual bonds for diversification purposes.
I’m keeping the individual bonds until maturity. That was always my plan. But the bond funds are being liquidated this week.
Source: Wealthy Retirement