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Bond funds take a beating

The Wall Street Journal offers an update on something SMI's executive editor Mark Biller warned about in our Oct. 2009 issue (as well as several times since): "safe" bond funds can suffer short-term losses.

Bonds are supposed to be safe, but the world's five largest bond mutual funds have all posted losses in the past two months — with three of them losing more in December than in November....

A selloff in U.S. Treasurys is spreading to most bond sectors, including corporate and municipal bonds. The yield on the benchmark 10-year Treasury, which moves in the opposite direction of price, has jumped about a full percentage point in the past month on fears that aggressive monetary and fiscal stimuli could trigger inflation and higher interest rates down the road....

While the five biggest bond funds are still up for the year, they have performed poorly of late. The $250 billion Pimco Total Return Fund, the world's largest bond fund, lost 3.42% from Nov. 4 through Dec. 17, compared with a 2.51% loss in the BarCap U.S. Aggregate Bond Index over the same period, according to Morningstar. The second- and fourth-largest bond funds, the $89 billion Vanguard Total Bond Market Index Fund and the $38.4 billion American Funds Bond Fund of America Fund, respectively, have lost 2.64% and 2.79%.

The losses were smaller in the $38.3 billion Vanguard Short-Term Investment Grade Fund, which lost 0.91% over the period in part because of the fund's shorter-duration securities, and $43.7 billion Templeton Global Bond Fund, the world's third-largest, which lost 1.29%....

Kenneth Volpert, head of Vanguard's taxable-bond group, attributes the losses in Vanguard's bond funds to the rising-rate environment.

The WSJ suggests that bond yields are rising because of the expected impact of "aggressive monetary [i.e., Fed] and fiscal [i.e.. White House/Congress] stimuli" that are pumping lots of money into the economy. That's one possible explanation, though as this post from last week suggested, some observers feel the recent rise in bond yields could merely be a return to more "normal" historical bond yields. As the economy eventually recovers to health, one would expect yields to rise from the record lows of the past two years.

Either way, as yields rise, bond values fall. No one wants to pay $1,000 for a bond paying 3% interest if there are new $1,000 bonds paying 5%, so the price of those older bonds has to drop to make them competitive with the new reality of the marketplace.

This is why long-term bonds suffer the most as rates begin to rise — and it is why we've been steering our readers away from long-term bond holdings for some time now. Shorter-term bonds, in contrast, suffer from rising rates for only a brief time, so they're better choices in times of rising rates.

We'll have more on this in our annual allocation article — coming soon in the January issue of SMI!

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