Many people invest in the bond market through funds because individual bonds can be difficult for non-professionals to analyze, and the trading prices for the small transactions typical of individual investors are often relatively high. When you invest through a fund, experienced portfolio managers make the buy and sell decisions, and your are able to take advantage of the more favorable trade prices that institutional investors enjoy.
Additionally, bond funds may hold dozens or even hundreds of different issues, reducing investors’ exposure to weakness in any one bond. Investing in bond funds rather than individual bonds can reduce risk in the fixed-income portion of your portfolio, but there still are possible pitfalls to consider.
Buying a bond is essentially making a loan. Your greatest risk is that the borrower will fail to make scheduled interest payments or fail to return the loan amount at maturity. In times of overall economic weakness or specific issuer problems, perceived credit risk may increase. Then, the price of some or even most of the bonds held by a fund might drop, reducing the value of investors’ shares. In the case of an actual default, the price decline can be severe.
To reduce credit risk, look for funds holding bonds from creditworthy issuers. For instance, bonds issued by the U.S. Treasury have scant risk of default. Corporate bonds are rated by private agencies and those from financially sound companies are considered “investment grade.” Standard & Poor’s, one such agency, gives AAA, AA, A, or BBB ratings to companies considered to have low credit risk.
Bonds that are judged to have more credit risk receive lower ratings or no rating at all. The term “junk bonds” may be applied to such issues, although they also may be known as “high yield” bonds because they must offer relatively robust payouts to attract investors.
When choosing a bond fund to invest in, research the ratings of the bonds held by the funds under consideration. A fund with average credit quality of AA, for example, would generally have little credit risk.
Interest rate risk
Another type of risk that bond funds are subject to is interest rate risk. Rising interest rates generally push down the price of bonds, even those without significant credit risk. That’s because higher interest rates make lower-yielding bonds less attractive. In such situations, bond prices drop to bring yields in line.
Interest rate risk is largely determined by whether the bonds in a fund are long- or short-term. Bonds that mature in the short-term have less interest rate risk than long-term bonds, because short-term bonds are subject to hikes in interest rates for a shorter amount of time. For example, in the case of a short-term bond that matures in one year, an increase in interest rates might not drive down the bond price very much because in just a year, an investor can redeem the bonds and reinvest the proceeds in bonds with higher yields that would presumably be available at the time of sale. In the case of long-term bonds, such as those with 20 or 30 year terms, a buyer would be locked into these bonds for decades, unable to put their money to work in the higher yield bonds that would presumably appear after an increase in interest rates. For risk reduction, you should look for funds with relatively short maturity bonds.
The bottom line is that high-quality short maturity bonds typically have less risk than lower quality long-term bonds. Bond funds holding lower quality or longer-term bonds will have higher yields. Thus, looking at a bond fund’s yield is a key indicator of the risks involved.
As of this writing, U.S. Treasury bonds maturing in the two- to five-year range yield around 2%. Therefore, any bond fund with yields significantly higher than 2% might be taking on meaningful credit risk, interest rate risk, or both. Lower-yielding funds may be relatively safe from share price deterioration.