Finally, Ordinary Investors Are Getting Smart About Bonds

The bond market has gotten unparalleled interest from investors in recent years, even as yields plunged due to the Federal Reserve's rate-reducing policies. As usual, it took big losses to convince mainstream investors to exit bonds, but they've finally begun to do so -- and their timing, while not perfect, should be good in the long run.

A stampede away from bonds
Investors sold $80 billion in bond mutual fund and ETF shares in June, according to figures from TrimTabs. That pace was much greater than ever seen before, with the outflows having jumped by more than $32.5 billion in just the past week.

The bulk of the outflows came from traditional bond mutual funds, accounting for more than $70 billion of the outflows. But TrimTabs said that $9 billion came out of bond ETFs, showing that both long-term investors and short-term traders think that the bond-market rout could have further to run.

Where the losses are
The impact of the abrupt rise in interest rates has rippled throughout the various niches of the bond market. In the Treasury market, long-term-focused iShares Barclays 20+ Year Treasury (NYSEMKT: TLT  ) has sunk by almost 10% since the first of April. Short-term Treasuries have seen smaller-percentage declines, but they've still eaten up multiple years' worth of interest payments in capital losses.

Municipal bonds haven't escaped the carnage, with iShares S&P National AMT-Free (NYSEMKT: MUB  ) falling about 6% in the past two months. Many closed-end municipal bond funds have taken much worse damage than that, with shares that had previously traded at premiums to net asset value now sporting substantial discounts and resulting in double-digit percentage declines for some funds.

Corporate bonds have also taken a hit, although shorter durations on some of the most popular corporate bond funds have limited their losses compared to longer-term Treasury ETFs. iShares Core Total Bond (NYSEMKT: AGG  ) has lost between 3% and 4%, while at the lower end of the credit-quality spectrum, SPDR Barclays High Yield (NYSEMKT: JNK  ) weighed in with a 4.5% loss during May and June. Especially at the higher-yield end, recent losses in the stock market have also contributed somewhat to junk bond declines, since junk bonds share many traits with stocks given their more speculative position in the capital structure than bonds of companies that carry better bond ratings.

Some of the worst declines have come from the international sector, where bonds have suffered the triple hit of falling exchange rates, rising rates, and in some cases, currency outflows as investors become less comfortable with higher-risk areas like emerging markets. Even dollar-hedged international bond funds have seen high-single-digit declines, while the unhedged WisdomTree Emerging Markets Local Debt ETF (NYSEMKT: ELD  ) sank almost 10%.

Why the herd is being smart
Mainstream investors are notorious for having bad timing, and waiting until after the bond market's recent swoon to start moving money out of bond investments looks bad from a short-term perspective. Recognizing the poor risk-reward picture in bonds could have prevented those losses.

Moreover, further outflows are likely still to come. Some investors will only learn of their bond-market losses once they receive their quarterly statements in the next week or so, and the loss in confidence in what many perceived to be a low-risk investment without the possibility of losing money could drive many to give up on bonds in the same way that many gave up on stocks after the market meltdown in 2008 and 2009.

But as big as these losses are, they're likely just the precursor to potentially larger ones down the road. Even after their big rise, interest rates have far to go before they reach normal levels. Rates may dip briefly after such an abrupt jump, but in the long run, getting investors out of the bond market will save them from what could become long periods of outperformance in the future -- and that could prove to be the silver lining in the bad experience bond investors have suffered over the past couple of months.

The right move for bond investors
If you've held bond funds and ETFs in the mistaken belief that they save you from risk of principal loss, it's not too late to take a critical look at the exposure you have to further interest rate risk and dial it down accordingly. Locking in recent losses might be painful, but the potential traps you avoid down the road could more than make up for those losses.

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Read/Post Comments (8) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 04, 2013, at 8:38 PM, charmboy wrote:

    HI Dan,

    "If you've held bond funds and ETFs in the mistaken belief that they save you from risk of principal loss"

    Could you elaborate on this theory, or lead me to a link that explains this idea further in detail.

    Thanks,

    Charmboy

  • Report this Comment On July 05, 2013, at 2:40 PM, MCCrockett wrote:

    Dan, with regard to Chamboy's question, is purchasing a bond ETF or an interest in a bond mutual fund really equivalent to buying a bond?

    If you buy a bond and hold it to maturity, there is an assurance that you will be returned your initial investment.

    If you invest in a bond mutual fund or ETF, that assurance seems to be missing.

    From 1983 to 2013, bond interest rates have been declining. The funds could always make money by selling their bonds before maturity at a premium and use the proceeds to buy more bonds yielding a lower rate.

    Now that we are moving into a period of constantly rising interest rates, how will mutual bond funds survive?

  • Report this Comment On July 05, 2013, at 4:28 PM, Richard07853 wrote:

    Is it a mistake to hold bonds for the income if u are not interested in trading them before they mature?

  • Report this Comment On July 05, 2013, at 4:44 PM, PaFrogboss wrote:

    MCCrockett makes a good point, which I don't see nearly often enough --

    Investing in bonds is entirely different from investing in bond FUNDS.

    I have a nice ladder of CAREFULLY SELECTED Corporates which are paying an average of 4.5% on face value and will eventually give me back most of my original investment (less whatever the premium was at the time of purchase) if I am careful to monitor the financials of the underlying company. If I see something going awry, I can sell the individual bond before I get seriously hurt -- just like investing in stocks! I am not dependendent on the skill of some investment manager, whose challenge is to constantly trade bonds in the rapidly deteriorating bond market.

  • Report this Comment On July 05, 2013, at 5:25 PM, plie65 wrote:

    Why in the world would my "wealth management advisor," (a ludicrous title for someone helping a retired school teacher who has all of $110,000. in savings and is 74 years old) have advised me to buy more bond funds about 4-5 months ago. Why doesn't he call me back and apologize and suggest something else to me? Managing money is not a suitable activity for poor people, I've decided. The quarterly reports show the bond funds losing consistently. Shouldn't my advisor have had some warning about this?

  • Report this Comment On July 06, 2013, at 4:42 AM, caveminh wrote:

    With all due respect to the author, this suggestion that investors dump their bond funds seems ill-advised. (The Motley Fool frequently pumps up stocks as if they were going out of style, but then fails to warn investors about the dangers of having a portfolio that is 100 percent composed of stocks.) Every investors should have a significant chunk of their portfolio in bond funds to act as ballast and to "zig" when the market "zags". This is what diversification is all about, and this is why you're supposed to be diversified across many asset classes.

    The only problem with diversification lately is that most of the asset classes have become increasingly correlated to one another - so they all zig and zag together at the same time. So while it used to be true that the Dow Jones was non-correlated to the Nikkei, nowadays, most of the stock markets around the world trade in virtual synchronicity with one another. Whether you consider REITs, commodities, US, or Foreign stocks - all of them have gotten to where they move in lockstep with one another. And this gives investors very few places to hide during a downturn.

    Now, this correlation may not sound like a big deal (you're probably telling yourself "I'll just ride out the storm until my portfolio recovers to where it was before the drop"), but having your entire portfolio drop the same amount as the Dow Jones during the next downturn is devastating to your long-term returns.

    How devistating? Just google the term "volatility gremlins" and you'll see Ed Easterlings data on how harmful variance from the average returns can be to the success of your portfolio.

    Although the average gain of the Dow might be 9 percent per year over the last 100 years, the "geometric returns" (or those returns that would actually materialize in your portfolio) would be about 2 - 3 percent less on an annualized basis. So instead of compounding at a rate of 9 percent, you're really compounding at a rate of 6 percent (and then 3 percent of your returns are really just inflation!)

    So please don't listen to these fools at the Motley Fool who are trying to trick you into dumping all your money into stocks after the market has just hit a 4-year high. Instead, just accept the fact that you need bonds in your portfolio (regardless of your age), and then buy bonds with shorter durations. For example, instead of buying TLT (with 20-yr maturities) buy SHY (with 1-3 year maturaturities). While the market is rising, it might be painful to see a chunk of your money *not* growing at 9 percent per year, but you will be so glad you're holding short-term bonds the next time the stock market takes a dive.

    And then, maybe you'll have some cash on hand to buy stocks when they reach basement-bargain prices!

  • Report this Comment On July 06, 2013, at 1:47 PM, ChrisBern wrote:

    Agree with caveminh. Bonds and bond funds are quite oversold at this point, whereas stocks and stock funds are quite overbought. It would not shock me in the least to see long-term bonds gain 5% or more in the next few months with stocks doing the opposite. Until there's any threat of the Fed raising rates, which trust me won't happen for at least 2-3 years, then bonds and bond funds will be a (relatively) safe place to be. Or just sit in cash, given that almost all assets are overvalued at this point.

  • Report this Comment On July 06, 2013, at 4:17 PM, MCCrockett wrote:

    The comment by caveminh provides an opportunity to ask another question. Why are the S&P 500 and Dow Jones Industrial Average indices held in such high regard as a measure of performance?

    I moved my 401(k) from a former employer into an IRA in 2003. I split the IRA into two accounts with each managed through a subscription to an investment advisory service. This seemed like a sensible approach given the 24x7 nature of my job at the time.

    Looking at a comparison graph of the S&P 500, DJIA, NASDAQ Composite, and Russell 2000 indices, I find that the NASDAQ Composite and Russell 2000 indices are a significantly closer match to my IRA performance from 2003 to 2013 than either the S&P 500 and DJIA indices.

    As caveminh points out, the S&P 500 and DJIA indices are synchronized and have had an increase in value of approximately 80% over the last decade. During the same period, the NASDAQ Composite and Russell 2000 increased roughly 150% and 170%, respectively.

    During the Great Recession (December 2007 to July 2009), all four indices bottomed out on 02 March 2009. Since then the DJIA has increased by roughly 130%, the S&P 500 by 140%, the NASDAQ Composite by 170%, and the Russell 2000 by 187%.

    The indices bottomed out again after the brouhaha over the National Debt cap and the initial concerns over the PIIGS debt obligations on 03 October 2011. Since then, the DJIA has increased by 40%, the S&P 500 and NASDAQ Composite by 45%, and the Russell 2000 by 62%.

    Why do we use the S&P 500 and the Dow Jones Industrial Average indices as performance metrics?

    Is it simply because a "classic" retirement portfolio with 40% of the portfolio in cash and bonds might be able to achieve returns similar to the S&P 500 and Dow indices? The IRA account that I have that is configured this way will, for the most part, perform as well as either of the indices.

    My IRA account that is only invested in equities and intended to support the last 15 years of my 30 year retirement generally outperforms all four indices; however, it only marginally outperforms the Russell 2000.

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