Understand the Risk of Investing in Some Bond Funds

Many investors hear the word “stock” and they think “risky.” Then, when they hear “bond” they think “safe.”

While it’s broadly true that stocks are more volatile than bonds — meaning their prices are likely to move up and down by wider margins and often more quickly — it’s really not accurate to think of bonds as being automatically “safe” as an investment choice.

For one, the safest type of bond, the U.S. Treasury, is not representative of all bonds in the market. There are corporate bonds, high-yield bonds, foreign bonds and so on.

The relatively volatility of any one of these bond investments is a matter of understanding how much risk you take investing in them.

For instance, a blue-chip U.S. corporate bond will be less volatile over time than, say, a foreign bond of a company that might appear to be in the same business sector.

That’s in large part due to accounting rules that make it easier to assess the risk of U.S. companies. But it’s also a matter of supply and demand.

If you own a blue-chip U.S. corporate bond and go to market to sell it, you are likely to get a price close to the current quote.

If you decide to sell the foreign bond, that’s naturally a smaller group of buyers. A price quote that seems acceptable could be quite different a half-hour later or the next day.

Bonds generally advertise their reliability through current yield. A low-yielding bond pays a low price because a lot of people want to own it.

Likewise, a high-yielding bond pays more to compensate for the fact that it has fewer buyers and those buyers want to be paid extra for taking on the risk of a potential loss.

Is the high-yield bond necessarily higher risk? Perhaps not, but the market is telling you that buyers want insurance just the same.

Triggered

All of the above relates to individual bonds. What if you buy a bond fund?

Here, the risk gets harder to parse, but it’s real risk. For one, a fund has to pay out to investors if they choose to sell and depart.

That means coming up with cash to redeem shares being sold. This automatically means the bond fund must maintain a certain level of uninvested capital to pay out to anyone who sells the fund, every day.

If there’s a rout in the bond market and people want out quickly, the bond fund’s managers are unlikely to have enough cash to pay everyone on the spot.

Like in a bank run, a bond fund now must stave off the ensuing panic and restore calm.

As investors begin to notice the bond fund is falling in value, that can trigger more selling and more panic. Given that the underlying bonds are usually quite safe, a bond fund panic is illogical — but it can happen.

One way to resolve the problem of a bond fund run is to avoid actively managed funds. In contrast, an exchange-traded bond fund (ETF) or bond index fund is going to hold all of a certain segment or index of the market in a weighted formula.

Because these are passive vehicles, it makes no sense to sell in a panic. In fact, ETFs are priced constantly through the day like a stock, so it’s even less likely that investors in the fund would question their ability to sell and receive cash.

Not all bonds are equal and not all bond funds are, either. Before investing, consider the performance record of the current managers, their fees and the underlying types of bond investments you will own in any given fund.

MarketRiders, Inc. is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.