Fed Funds Rates vs. Bond Mutual Funds

June 27th, 2013 by

federal reserve buildingThe sky is falling! Well at least it appears to be in the bond markets. I guess we cannot refer to this as a “Great Rotation” being that stocks have been getting hit pretty hard with the Fed’s recent decision to announce that an end of their stimulus efforts is on the horizon. The simple fact is that as interest rates rise, bond prices will fall. However, history has shown that the gloom and doom prediction that is being predicted for bond holders and bond mutual funds today, has not exactly held true in periods of rapidly rising interest rates of the past.

I do not, and have never owned individual treasury bonds. However, if you are an individual bond buyer then you should expect to see (on your statement) the value of your bond decline as interest rates increase. You will only experience a loss of principal in the event of default or if you choose to sell your bond prior to maturity at a price below what you paid for the bond.

Owning one individual bond is much different than owning a bond mutual fund. Yes you will see some downward pressure on the net asset values of bond funds, but the diversification that bond funds offer will certainly leave individual investors better positioned than the individual bond buyer throughout this very scary period. There are several reasons for this and here are a few:

1) Most mutual funds are comprised of hundreds of different bonds with different maturity dates
2) As current bond holdings mature, the managers will be able to reinvest the proceeds at higher rates
3) Like equity mutual funds, bond mutual funds are also included in many plans, such as 401k’s, that continue to pour new money into the funds on a monthly basis. This money can and will be invested at higher rates.

I’m not claiming that bond mutual funds will prosper and provide extraordinary gains during a long-term period of rising interest rates (that easy money has been made already), but you need to understand that there are two sides to every coin. If interest rates rise over the next 12 months then a whole new crop of investors will be enticed by a higher dividend yield these funds may be offering at that time, and that attracts new dollars. The easy money has been made in these funds, and the risks are all to the downside, but that does not mean you should expect to lose half the value of your current bond mutual fund you are holding.

Let’s take a look at the period ranging from November 26, 1976 to December 31st 1980. During that period of time the Fed Funds Rate went from 4.75% to a range of 19% to 20%. This kind of makes todays worries about rates look a little ridiculous doesn’t it? Now let’s look at the returns of two of the oldest bond funds in the world for that period of time. Please keep in mind I am not endorsing either of these mutual funds. The American Funds Bond Fund of America A (ABNDX) gained 16.29% from November 26, 1976 to December 31, 1980, while the Putnam Income Fund A (PINCX) made 8.01% and the average intermediate-term bond fund made 12.10%. I am not suggesting that these returns are good. I am merely trying to show that this theory that we are falling off a cliff and thus you will lose tremendous amounts of principal value in your current bond mutual fund has not exactly held water. It certainly didn’t during the largest increase in the Fed Funds Rate in the modern era.

I believe the real risk in the above example, are the same risks holders of bond mutual funds face today. That risk is the unseen risk of inflationary effects or a loss of purchasing power. Sure holders of those funds had more money on paper at the end of the period researched, but after adjusting for inflation for that period of time, much of the gains were wiped out. If you want a growth rate that historically exceeds the rate of inflation then do no look for it on the bond side of the portfolio. The real risk going forward is the risk you cannot see on your monthly statement.

Look for bond funds that afford their managers a tremendous amount of flexibility. Being able to sit on large sums of cash and not being mandated to own a certain type of bond will be the key to bond fund returns over the next five years. In 2000, when the Fed raised rates aggressively to combat the effects of the internet bubble, Bill Gross was right there buying new 10 year corporates paying 8%. That is where the good managers separate themselves over the long-term.

For a more detailed view of my approach to owning bonds please read my article from last summer here.’

Jon R. Orcutt
Founder of Allocation for Life
Author of The Allocation for Life Investment Newsletter
Author of “Master the Markets with Mutual Funds: A Common Sense Guide to Investing
www.allocationforlife.com

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