How Attractive are Bond Funds Right Now?
Bond funds have experienced a huge leap in popularity recently. While bond funds can be a useful tool, it is important that we understand their proper uses to get the most of them.
A lot of people invest in stocks as their primary holding, and they understand pretty well how stocks work and what they are for. You buy them at a certain price and hang on to them for a given period of time and hope to sell them for a profit.
Stocks also pay dividends, and therefore we’re looking to make money from investing in them two different ways, by shooting for capital gains and dividend income. The focus is mostly on the capital gains though and having people understand stocks in this way allows them to manage their positions with at least an understanding of what the primary objective of this investment is so they can act accordingly.
It is not that dividends don’t matter at all though and they do add to the total return of the investment accordingly. Some people prefer to invest in stocks where dividends play a bigger role in the potential return of the stock, but price is still going to be the main driver of common stock returns.
People are told that they should look to balance off the risk of their stock positions by putting a certain percentage of their portfolio in bonds. Should we be in a bear market with stocks, this strategy will result in lower drawdowns because less of our money will be exposed to this stock downturn.
We at least need to realize though that if we are planning on holding through the downturn, which we at least presumably would be given that we would just sell our stocks if not, the risk during the bear market isn’t even a relevant one, as we need to confine our concerns to points where we actually will be selling.
If you had a choice between going all stocks or half bonds and you were standing at the precipice of the 2008-09 market decline, just going with stocks is going to produce a lot bigger return, because that’s what stocks do over bonds.
We tend not to perceive risk very well and there are legions of people who misunderstand it enough to feel grief during market pullbacks even though they have no intention of selling regardless of what happens. While this might not be the best way to manage our money, as we can benefit from timing our stock plays, there is still something to be said about buy and just hold, although if we do this, we also need to buy and forget.
We can break down risk here into actual and what we could call psychological risk, the risk that you will be bothered by perceiving risks that aren’t even there. There are risks that we want and need to manage and those where the better move would be to understand them, and to the extent that these imagined risks are influencing us, we will be over-hedging.
There is always a risk that we may enter and remain in a very enduring bear market that could last however long that our time horizon is, but this is so unlikely that it is not really worth considering. Aside from that, we do need to ensure that we’re not exposed to actual drawdown risk, which is during the time we’re looking to cash in.
Bond Funds Have Become Enormously Popular Lately
If we’re going to be taking money out of stocks, we need to put this money somewhere, and bonds are by far the asset of choice among investors. While some may hold treasuries, bond funds have become much more popular now and do the same thing for bonds that funds have done to stocks.
We’re also told that we should diversify, and although we may end up diversifying far more than we need to, this would require a diversified bond position overall. This has not been possible for the overwhelming majority of investors, until bond funds came along that is.
Bond funds have exploded in popularity lately, and this is still accelerating, with 2019 set to be the best year for inflows into them by a wide margin. The story we’re hearing about bonds might scare some away though, although if there are concerns, it’s important to understand what we should and should not be concerned about, which will require a basic understanding of bond funds.
Bonds, like stocks, can make money two ways, by the price going up and by earning interest like dividends do. The interest that bonds pay doesn’t vary like dividends do, and while dividends only play a small role with stocks, interest payments are a much bigger deal with bonds and is where their value is derived from.
The first thing that we need to do in order to understand bond funds is to realize that these funds do not mature like bonds do, where you can just buy the yield and not worry about price. We therefore have to approach funds with the same mindset as those who hold bonds for lesser periods than maturity, where we need to take account of price as well.
This is because shares in a bond fund represent the aggregate holdings of the fund, which may have various securities maturing at different times but they remain invested. You’re going to pay a certain price for a share when you buy them and get a certain price for it when you sell it, The difference in these prices will represent your capital gain or loss on the transaction, so this stuff does always matter no matter what your strategy may be.
Bond funds aren’t just about what the current yield on the bonds that they hold, and it’s never just a matter of looking at where the yields are and deciding whether to invest. Yield and price move in different directions, and if we expect yields to go down, this actually means that our bonds will be worth more.
We are essentially just buying the income flow with bonds, the interest that they pay, although with bond funds we need to pay attention to their price, the same way as we would with our stocks. When the demand for either stocks or bonds increases, their price rises, and vice versa. This is a concept all investors are familiar with.
Perhaps the best thing about bond funds is that they require that we do no math here, as we can watch the value of our positions change just like we would with a stock chart. Everything is reflected in the price of the fund.
We need to realize that anytime we invest in a bond fund we are speculating, as opposed to just holding the security to maturity. That even involves some speculation, as you are speculating on the value of this strategy versus other ones, but bond funds involve speculating on price directly, the only variable in this investment.
With Bond Funds, It’s All About Timing
While the goal with bond funds is to make money, they aren’t going to provide returns anywhere near what stocks can, and most people don’t even appreciate how big of a difference there is here, using numbers like 6% for stock returns that include a lot of data that is way too old to matter. When we look at more recent history, we see returns far in excess of this even though we’ve had a couple of market crashes during this time.
Bonds make sense when stocks don’t, which includes both when we can’t expose ourselves to the risk due to an upcoming redemption or when being in stocks just might not be a good idea. Whenever we look to change assets though, we also need to pay attention to how the new asset is performing, as moving to one that isn’t performing well is never a good idea.
Whether or not we wish to move into bonds right now will really depend on their outlook. If we can buy a fund and have a positive expectation overall, and this is the best alternative, then it makes sense to do so. However, if our overall expectation is negative, that should put an end to the discussion, as keeping our money under the mattress has a better expectation.
This is the part that so many end up missing, and there are plenty of times where being in a bond fund just isn’t a good idea. We’re told that right now, with yields so low, bonds aren’t such a good choice, and therefore bond funds aren’t either.
The real reason why bond funds don’t look so good right now isn’t because of this, and yields declining is generally a good thing for bond funds. They have gained quite a bit in value since last December, since yields have been dropping, and are continuing to climb.
The problem though is that bond funds have a limited upside once you see them go up this much, and that’s the real reason to be hesitant right now. The best way to understand this is to look at the average of your fund over time and compare it to where you are now to see where you may end up at the time that you’re looking to sell this if you’re looking to get an idea of what the long-term view with these investments is.
It very well may be that bond funds hold up for the next few years, and with the economic data that we have, this makes sense. If we are looking further out than this though, all this demand for bonds can’t last forever and this is where we need to be concerned.
Bond funds are tradeable though, and can be bought and sold immediately with a bond fund ETF or within a few days with a bond mutual fund. We can still buy bond funds even in this high-priced environment, so long as we’re aware that the goal shouldn’t be to take a hit with them by riding them down too much.
Bond funds don’t have the upside that stocks do and their prices move between fairly tight ranges compared to stocks. It’s not that you can just hold them for long periods and expect them to just keep going up.
Bond funds need to therefore be treated more like the way we treat gold, or at least should treat it, as far as needing to time our bond fund holdings go. This is the part that so many people miss, and this is what causes them to enter at inopportune times.
It’s not so much where we enter as it is what we will do once we’re in the funds, and if this means not really paying attention to price, we’re doing ourselves a disservice. There’s really nothing that scary about bond funds right now, and while this may not be the ideal time to invest in them, we can do so fairly safely as long as we do have our safety in mind.
Editor, MarketReview.com
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