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When we build an investment portfolio it should include a mix of higher risk securities as well as safer investments. This usually divides the portfolio neatly between stocks and bonds. And with mutual funds and exchange traded funds (ETF’s) being so popular, that usually means stock funds and bond funds. But are bond funds really that safe?

This question is more important than it seems at first glance.

Perception of Safety vs. Reality

We might think of bond funds as being safe investments because they include bonds, and bonds are considered safe. But a bond fund is not always safe and, for that matter, neither are bonds in all instances — more on that later.

If you have a portfolio that includes 70% equity funds, and 30% bond funds, you might think that the portion invested in bond funds has you covered in the event of a decline in the equity portion. But don’t bet on it!

4 Things to Know about Bonds and Bond Funds

Bond funds can rise in value, but they can fall as well

A bond is an investment in a single security. If you buy a 30 year US treasury bond paying 3%, you’ll know exactly what you have. If you invest in a bond fund you’ll have a mix of bond investments of varying maturities, interest rates, and even risk levels.

While the fund may consist entirely of bonds assembled in a portfolio designed to maximize return and minimize risk, the funds rarely provide complete safety of your investment value. Bond funds can rise in value, which makes us happy, but they can fall as well. When we’re looking for a fixed income allocation in our portfolios, that isn’t necessarily what we have in mind.

When markets are rising we may not pay much attention to this factor. When markets are falling, and safety of principal becomes a priority, bond funds may not fill the role that we expect.

Stocks and bonds often rise and fall together

One of the problems with bond funds as a counterweight to stock funds is that the two are not necessarily mutually exclusive. In fact they may not be mutually exclusive at all.

Bonds often rise and fall along with stocks. There are different reasons why this happens.

One can be the state of the economy . As the economy improves stocks rise because of higher sales and profits. Bonds will generally rise as well, because improving economic conditions improve bond quality. The onset of a recession can cause both stocks and bonds to decline in concert.

. As the economy improves stocks rise because of higher sales and profits. Bonds will generally rise as well, because improving economic conditions improve bond quality. The onset of a recession can cause both stocks and bonds to decline in concert. Interest rates are another major factor that affects both stocks and bonds about equally. The prices of both stocks and bonds tend to rise when interest rates fall. Conversely, prices of either security also tend to fall when interest rates rise. In this scenario, bonds and bond funds provide little real diversification to stocks.

Bond funds often take on more risk to increase yield

Many funds chase yield, and that includes bond funds. Investors are always looking for a higher rate of return on their investments. Even on their safe investments they will try to maximize yield. Bond fund managers are aware of this and often work to maximize the yield of the fund.

The problem with this approach when it comes to fixed income investments, is that by increasing yield the fund also takes on greater risk. Since most investors expect their bond holdings to provide safety of principal, exchanging higher risk for higher yield defeats the purpose.

At the extreme of bond funds are those that hold junk bonds. These are low grade securities that provide above average returns. You might invest in a bond fund that invests primarily in these securities, which is not a problem if you recognize the additional risk you are taking. But if a bond fund manager adds a small percentage of junk bonds to the fund in order to increase yield, he’s also increasing the risk that some of the securities may default. Worse, those defaults tend to accelerate during declines in the stock market.

Bonds are great when interest rates are falling

Earlier we touched on the inverse relationship between bonds and interest rates. Bonds rise in price when interest rates fall, and fall when interest rates rise. This makes bonds less of a play on safety and more of a play on interest rate swings.

Bonds can be an excellent investment if interest rates are high and looking likely to fall. In such a market bonds can function in much the same way as a dividend paying stocks — rising steadily in value while providing immediate return (interest) on your investment. That’s a best of all worlds investment.

If however, we’re in a very low interest rate environment, and a rise in rates seems likely, bonds can be expected to fall in value AND you can also be stuck holding low interest rate securities at a time when higher rate ones are available. That’s a worst of all worlds investment! That’s also closer to the environment that we’re in right now on the interest rate front.

The bond/interest rate relationship actually has very little to do with safety at all.

Safer Investments

To offset the risk from your stock holdings, it will be best to look beyond bonds and bond funds, and instead to add short-term, interest-bearing investments to your portfolio mix.

This will include money market funds, and US treasury bills and bank certificates of deposit (CD’s) with maturities of one year or less. These securities will offer the lowest interest rates available, and have a slight negative real return, however they will provide the greatest safety of principal possible. In addition, in a rising interest rate environment the securities will keep their value and mature quickly, enabling you to take advantage of higher yields as they develop.

This is the kind of investment that most people are looking for when they invest in what are loosely called “bonds”. Risk-less investments are what are really needed to offset volatility in a portfolio. Money market funds, T-bills, and CDs provide that kind of protection. Bonds and bond funds don’t.

We might properly think of bond funds as being an intermediate investment, floating somewhere between truly safe assets and equities. But safe? Not really!

Do you have a different view of bond funds?