Nightmare in Bonds and Bond Funds?

When interest rates are low and stocks are falling, bonds in the form of bond funds look attractive to many investors looking for higher income. Quality bond funds can offer dividend yields of 5% or more when bank CD's are paying about 2%, and money market rates are even lower.

Look twice before you leap into a bond fund in a low interest rate environment. Interest rate risk looms, and could be a future nightmare for investors.

There is a huge risk differential between investing in bond funds vs. money market funds or CD's at the bank. The latter are very safe investments. When you invest in bond funds you are investing in bonds. Interest rate risk applies. It could be very risky to chase higher income by buying bond funds in a low interest rate environment.

Interest rates in 1981-1982 went to historical highs, well into the double digits. In 2008 and early 2009 rates hit historical lows. Many investors looking for higher income with safety looked to bond funds for dividend yields of 5% vs. less than 1% offered by safe money market funds. Let's look at the big picture.

The problem with investing in bonds, bond funds, when interest rates are real low is three-fold. First, new bonds being issued offer historically low coupon interest rates. Second, bonds are long-term in nature and their coupon rate of interest paid is fixed for the life of the bond. Third, interest rates in the economy fluctuate.

Keep in mind the following. People invest in bonds and bond funds in order to get higher income. Bonds trade much like stocks do, so their price (or value) fluctuates. When you buy shares in a bond fund, you are invested in a portfolio of bonds.

Now, with interest rates near historical lows picture JKL Bond Fund. This mutual fund holds a portfolio of long-term bonds, on average maturing in 20+ years. The bonds are of high quality, and the fund's dividend yield is 5%. Think early 2009.

Now visualize a nightmare. You buy shares in JKL Bond Fund, and then over the next couple of years interest rates double. New investors can now buy JKL Bond Fund and get a dividend yield of 10%. What does this mean to you?

Bond investors will bid down the price of the bonds in JKL's portfolio as interest rates rise. When interest rates hit 10%, investors can pay $1000 for a new bond that pays $100 a year in interest until it matures many years down the road. Then they get their $1000 back. There is no reason for anyone to accept less than a 10% yield.

The value of an older bond issued at a price of $1000 with a fixed coupon interest rate of 5% paying $50 a year in interest will fall like a rock. Using simple math, in order to get 10% in yearly income from this bond, you might be willing to pay a price of $500...interest of $50 a year divided by $500 equals 10%.

If interest rates double, the share price of a fund like JKL will take a big hit. Bond fund prices or values would not likely fall in half, but would head in that direction. This is the concept of interest rate risk, and it is real. When interest rates go up, bond prices fall.

DURATION is a number that measures interest rate risk for investors. The higher the duration of a bond or bond fund (average duration) the greater the risk. A high duration figure means that a bond or bond fund's price is very sensitive to changes in interest rates.

If you want relative safety in a bond fund, look for one with a low AVERAGE DURATION.

A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.

Jim is the author of a complete investor guide, Invest Informed, designed for average investors or would-be investors of all levels of financial background and experience. To learn more about investments and investing and his new financial guide go to http://www.investinformed.com.