Bond funds can lose money.
With rising interest rates on everyone's radar, portfolio managers are keen to warn investor clients that bonds, bond mutual funds, and exchange-traded funds can lose value.
It's a hard concept to understand. First, some context: Underlying bond prices have risen for decades, as interest rates have fallen. Many investors only remember bonds increasing in value. That could end.
"Institutional and retail investors are both concerned about losses from bond portfolios. We're conditioned to understand losses in our equity portfolio. But given a 30-year bull market in bonds, few are familiar with losses" in bonds, explains Andy Toburen, portfolio manager of the Chartwell Short Duration High Yield Fund (CWFAX), based in Berwyn.
"They can expect that to happen when rates start to rise," Toburen says.
His mutual fund invests in short-term bonds to guard against rate hikes, and, yes, Toburen has his own money in the fund.
Charles Weeks, founder of Barrister Wealth Management in Galloway, N.J., explains the concept of bond-price movement to his Stockton University students frequently.
"I tell students to imagine a seesaw. When rates go up, bond prices fall. When rates go down, bond prices rise."
Put simply, when rates rise, the U.S. government or a corporation issues new bonds at newer, higher rates. Older bonds, paying the old, lower interest rates, aren't in demand. They fall in price.
If and when rates rise, "you could get statements showing you have less money," Weeks says. (There's a great explanation on the Investopedia website, www.investopedia.com/university/bonds.)
Here's another wrinkle: Fixed-income ETFs and mutual funds also can drop in price.
"In a bond mutual fund or bond ETF, there's no return of principal. Bond funds can also lose money if interest rates rise in general, but especially if rates spike," Weeks says.
He points to the bond exchange-traded fund TLT, which holds long-term Treasuries and has dropped from $127 a share to $123 year-to-date.
Weeks recommends only a portion of assets in bond funds or substituting into cash or very short-term bond funds like IEI or SHY.