Perceiving the Possible Evils of Bond Funds
By Bob Payne, Managing Director and Chief Investment Officer (CIO)
As a young financial advisor working for Merrill Lynch in Philadelphia during the late 1970s, I remember selling a bond fund called a federal securities trust. It couldn’t have had a better marketing label: high-yield, government-guaranteed, diversified portfolio, and professionally managed. Around the same time, my first son Ryan was born. So I bought him a zero-coupon treasury bond that we locked in at 14.25% compounded.
When rates go down, money pours into bond funds
The flip side is if rates rise, money flows out of bond funds
PCM counteracts this potential volatility by focusing on bonds with maturity dates
That was such a great investment. Not only did we make enough to pay for Ryan’s college tuition at Villanova, but there was actually money left over that we gave to him as a gift. However, I learned about the possible evils of bond funds two years into that investment. Ryan was up dramatically on the fixed income investment at the time, while my clients had only an 11% current yield and their portfolio was down. How ridiculous is that?
The reason is when rates go down, money pours into bond funds. Then the evil thing that happens is money will come flowing out if rates rise. There was a great article recently on CNBC titled “Check Your Bond Funds before Interest Rates Rise” that actually refers to bond funds as a ticking time bomb. It includes an interview with the Head of Fixed Income at AllianceBernstein, who says that if rates were to rise by just 1%, many of these funds could lose as much as 7.5% in one year.
Do you know what will happen if rates go up 1% and the portfolio declines 7.5%? You personally may not panic out, but millions of people who are invested side-by-side with you will. Then you’ll get penalized by the panic of those other people, because a bond fund is a collective investment of everybody’s portfolio.
How do you fix that? By having a fixed income portfolio with permanence and definition. It’s unavoidable that bonds will go down when rates go up. But every single one of the bonds that PCM owns has a maturity date, so by holding the bonds until they come due our clients will ultimately make more money and have a portfolio that gets reinvested at a higher interest rate.
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