Fixed Income Bond Funds – Comments on Recent Volatility and Potential Rising Rates

Fixed Income Bond Funds – Comments on Recent Volatility and Potential Rising Rates

By Thomas H. Giedgowd, CPA, MS

Key Points:

– Most individual investors allocate a portion of their retirement plan and/or other investments to fixed income funds in order to lower their risk tolerance and volatility that exist in stock equity funds.

– Bond funds and their individual bond components share interest rate risk which is the risk of locking in a bond investment at a given interest rate.

– For stock equity funds the primary source of investor returns is rising stock prices. However, dividends can be meaningful for some equity fund types but are a secondary source of return for most.

– Returns from bond funds come from two sources which are interest payments and changes in price. Over time interest payments typically contribute more to returns than changes in price for most bond funds.

– Bond prices will decline if interest rates rise and the longer the bond fund’s average maturity the larger the decline will be when rates rise.

– This price decline is not a “realized” loss unless you or the fund manager chooses to sell the bond before maturity. Bond prices

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move back towards par at maturity and most bonds continue to generate interest payments.

If you are invested in bond funds as part of a diversified portfolio or for income, what options do you have if interest rates start to rise or are perceived to rise?

The following comments are based on the assumption that individual investors have a long term time horizon with respect to their bond allocation.

Selling Your Bond Funds/Individual Bonds

– Will have no tax consequences if sold within a qualified

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account (i.e., 403(b), 401(k), IRA).

– Will have either a taxable realized loss on gain if sold outside a qualified account. You will need to know your tax basis in the bonds sold to ascertain whether the sale generates a realized gain or loss.

– Even though most bonds have declined in value over the months of May and June, don’t be surprised if you find out that you would have a realized gain on the sale especially if the purchases were made over the previous years.

– You will now have to make a decision when and where you want to reinvest the sales proceeds. Market timing as well as future interest rate projections are difficult to predict.

– Most investors will still want to maintain their target asset allocation between equities and fixed income/bonds to maintain their risk tolerance levels.

– Returns on money market and stable value funds historically have been lower than bond funds over the long term.

Holding Your Bond Funds and Reinvesting Monthly Interest Dividends

– When bond fund prices decline you will be buying more shares, due to cheaper prices, with the monthly reinvesting.

– Bond prices move back to par at maturity.

– Recurring interest payments from bond funds are still generated during periods of bond price declines. Bond price declines cause higher yields mathematically.

– When bonds in the fund mature the fund manager is able to reinvest principal at higher yields as rates rise.

– Bond fund investors who have a long term time horizon have previously enjoyed many years of healthy returns combining interest payments and positive changes in price sometimes called the 30 year bull market for bonds.

– The Barclays U.S. Aggregate Bond Index is often used to represent performance in a diversified investment grade bond fund. The 6/30/2013 year to date return was down (2.4%).

– This decline can be viewed as the bond markets adjustment to fair market value for this period taken in context with the prior bull market for bonds.

Summary

The outlook for global growth and inflation remains low indicating that interest rates should not rise dramatically and/or should remain at relatively low levels currently.

Professionally managed bond funds can be diversified to include the following types of bonds with various durations:

– Government bonds

– Agency bonds

– Investment grade corporate bonds

– High yield bonds

– Emerging markets debt

– Municipal bonds

Investors should always review their target allocation as to fixed income and equities to ensure that it is consistent with their risk tolerance level, time horizon and diversification.

Carroll Consultants, Ltd. (CCL) is a leading provider of retirement plan services. As part of its investment advisory services, Carroll Consultants Advisors, Ltd. (a subsidiary of CCL) provides fiduciary education and investment advice to plan fiduciaries. To learn more on how Carroll Consultants Advisors, Ltd. can help you and your plan, please contact Marcie Carroll, (610) 225-1210, or mcarroll@cclbenefits.com.

The information provided here is for general informational purposes only and should not be considered an individual recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.