How Risky Are Bond Funds Today?

It is a truth universally acknowledged that a retail investor in possession of a good fortune must be in want of a low-risk asset class in which to stash some of it, and that bonds are among the best options of that type. But -- with deepest thanks and apologies to Jane Austen -- universally acknowledged truths sometimes turn out to be false under certain circumstances.

Case in point, from deep in this month's Motley Fool Answers mailbag comes a query from a listener who was disturbed to read an article in The New York Times asserting that corporate debt is experiencing a valuation bubble, and that bond funds have become a riskier place to invest than most people recognize. Is this true, he asks, and if so, what should an investor do in response? To answer, special guest Buck Hartzell, director of investor learning and operations at The Motley Fool, joins hosts Alison Southwick and Robert Brokamp in this segment.

A full transcript follows the video.

This video was recorded on Oct. 30, 2018.

Alison Southwick: The next question comes to us from Guy Over There. "If I understand the general suggestions around preparing for a goal like retirement or college, the idea is that the closer you get to needing the money, the more you should be moving it from stocks to bonds and cash. However, an article in The New York Times has scared the bejesus out of me.

"The article titled, The Big, Dangerous Bubble in Corporate Debt, by William Cohan, makes it sound like there are a lot of mutual funds that have riskier corporate debt than one might assume. So if I wanted to liquidate some of my shares out of these bond funds to pay for college in a couple of years, I run the risk that the bond prices, and thus my mutual fund values, might be depressed just as I need to sell. What's your take on this? Do we all have a lot more risk in our bond funds than we might think?" Dun dun duuuun!

Robert Brokamp: Dun dun Duuuun! I'll just piggyback on what Buck said. Clearly there is more risk in the bond market these days when you have rising interest rates and we've seen that this year so far. For example, the aggregate bond index -- this index started in 1976 -- is on track to having its second worst year ever. And what does that mean? It's down 2.5%. So it's not a huge decline, but if you are saving for retirement, or if your retirement's coming up, or you have college coming up, you don't want to see your so-called safe money go down any kind of value.

He also raises a point in that there are some questions about the make-up of some bond funds, now in that they are getting riskier. For example, one stat that I read in a Business Insider article was that when you look at investment-grade bonds, those are rated BBB and above, and that's what most bond funds are. They're investment grade. But if you look at the aggregate bond index, 50% of those bonds are rated BBB, so basically right above junk as opposed to just 38% right before the Great Recession. So there is something to be said that the average bond fund is riskier these days, just because it ends up holding more bonds with lower ratings, so I think it's a valid point.

The bottom line for me is again to what Buck said. These days bonds are very unattractive. If you need to keep money out of the stock market, especially if you want to keep it very safe, I think cash is really the best way to go. And the good thing about that, nowadays, as we've said before on previous episodes, is that when the Fed hikes interest rates, you can almost see it immediately in a good savings account or in CD rates.

You have to look because a lot of banks and brokerages are still paying virtually nothing. Counting on everybody being lazy and not going out there and looking for better rates. But if you go out you will find you will be able to earn more than 2% -- almost 3% -- on your cash, and I think that's more attractive for money that you absolutely need to keep safe than a bond fund these days.

Buck Hartzell: You've got to consider the risks and rewards, and I think right now you're not being paid a whole lot of reward for taking on that risk, so I would be in cash, too. I own no bonds, but even with college stuff and things, if you've saved $100,000 the upside is maybe you eke out an extra percent or so. That's $1,000. That's not going to make the difference on whether they go to college or not, so I wouldn't take the risk with money that I knew I needed in the next two or three years.

Brokamp: I'm not saying you shouldn't own bonds, by the way. If you have a long-term portfolio and you don't want to have all of your money in stocks, I think a diversified bond fund can still make sense. Just as long as you know the risks, I think over a span of five to 10 years, studies have shown that rates going up over the intermediate to longer term is actually good for a bond fund, because the new bonds that they buy have [higher] interest rates. So I think you can still earn more than cash over the long term but stick with cash if you want something that's absolutely safe.