| p>According to Plan Sponsor magazine bond | | | | cause bond mutual fund share prices to decline. |
| mutual funds saw a record inflow in 2009. | | | | If the economy softens, we will investors start to |
| (According to article - Bond Funds See Record | | | | question the credit worthiness of the bond's |
| Inflows in 2009 published January 15, 2010) In | | | | issuer? Will the current creditworthiness concerns |
| fact, Strategic Insight, which is an Asset | | | | about both sovereign debt of Portugal, Greece |
| International company, announced that full year | | | | and Italy spread? Again, any "force" that causes a |
| 2009 inflows to bond funds were an all-time | | | | concern about the creditworthiness of an issuer |
| record of $396 billion! Conversely, stock mutual | | | | will be a negative for bond prices. |
| funds, excluding Emerging Markets, were only | | | | Inflation Risk |
| around 30 billion. Over longer periods of time | | | | Choosing an investment solely for its stability |
| stock mutual funds garner a significantly larger | | | | entails inflation risk. Inflation erodes the purchasing |
| share of mutual fund inflows than do bond funds. | | | | power of any investment. For example, suppose |
| However, considering investor's disappointment | | | | $1,000 in a deposit account earns 5 percent |
| with the stock market in 2008 and early 2009 as | | | | interest, but inflation is 2 percent per year. |
| well as overall investor anxiety, it's not surprising | | | | Although this money will earn $50 in interest after |
| to see investors seek the perceived relative | | | | one year, inflation cuts the actual worth of this |
| safety of bond funds. (In Article Bond Funds Take | | | | $50 down to $49. In addition, the initial $1,000 will |
| in Record $396 bln in 2009 published by Reuters, | | | | also erode by 2 percent to $980. Therefore, |
| January 14, 2010) | | | | after one year, the deposit account has a balance |
| Unfortunately, bond funds are not necessarily | | | | of $1,050, but due to inflation, it is only worth |
| safe. And the record inflow into bond funds | | | | $1,029. This is the effect of inflation risk. To |
| suggests the possibility of investor disappointment | | | | maintain an investment's value, its total return |
| as we move forward. To the point of potential | | | | must keep pace with the inflation rate. |
| investor disappointment, recall that in late 1999 as | | | | The Effect of Inflation |
| the tech bubble was heading toward its peak, | | | | In 2005, the inflation rate was about 3.4 percent. |
| investors were placing incredible sums of money | | | | Even at this historically low rate, inflation will erode |
| into stock mutual funds that focused on | | | | the value of $1,000 by more than one-quarter in |
| technology stocks. By the end of the first quarter | | | | 15 years: |
| 2000, the NASDAQ had peaked in price and over | | | | In this many years... $1,000 will be worth... |
| the next two years declined 75%. More recently, | | | | 5 --$846 |
| during the housing and commodity bubble | | | | 10 --$716 |
| investors had a strong bias towards homebuilding | | | | 15 --$606 |
| and commodity stocks only to watch their prices | | | | 20 --$512 |
| crater. Thus, I'm wondering if investors are on the | | | | 25 --$433 |
| verge of making the same mistake with bond | | | | 30 --$367 |
| mutual funds. To be sure, bond funds certainly do | | | | 35 --$310 |
| not have to go down in price; however, history | | | | 40 --$263 |
| suggests that many investors tend to be ill-timed | | | | Assuming 3.4 percent annual inflation |
| with their investment decisions. Whether bonds | | | | Many market prognosticators expect that inflation |
| are positioned to go down in price or not, it's | | | | will ultimately rear its ugly head as the economy |
| prudent to make ourselves aware of the potential | | | | strengthens and/or the market place reacts to |
| risks. According to the Investment Company | | | | the incredible sums of money that global |
| Institute, which is a national association of U.S. | | | | governments have printed to combat the global |
| investment companies that includes mutual funds | | | | recession of 2008-2009. If so, this is another |
| and whose members manage total assets in | | | | negative to consider, especially if you view your |
| excess of 12 trillion for over 90 million | | | | bond money as "safe." |
| shareholders, some of the inherent risks of bond | | | | IMPORTANT: No Guarantees Available |
| mutual funds are as follows: | | | | There are no guarantees when investing in a bond |
| Interest Rate Risk | | | | mutual fund. Even if the individual bonds in the |
| Bond prices are closely related to interest rates. | | | | fund are guaranteed by the government or |
| When interest rates go up, most bond prices go | | | | insured through a private insurer, the value of a |
| down. When interest rates go down, bond prices | | | | bond mutual fund investment can still rise or fall. |
| go up. | | | | Bond mutual funds are not insured or guaranteed |
| The longer a bond's maturity, the more its price | | | | by the Federal Deposit Insurance Corporation |
| tends to fluctuate as market interest rates | | | | (FDIC), the U.S. Securities Investor Protection |
| change. For example, a rise in interest rates will | | | | Corporation (SIPC), or by any other government |
| cause a larger drop in price for a 20-year bond | | | | agency, regardless of how a bond mutual fund is |
| than for an otherwise equivalent 10-year bond. | | | | purchased or sold-through a brokerage firm, a |
| However, while longer-term bonds tend to | | | | bank, an insurance agency, a financial planning firm, |
| fluctuate in value more than shorter-term bonds, | | | | or directly. Nor are they guaranteed by the bank, |
| they also tend to have higher yields to | | | | brokerage firm, or other financial institution where |
| compensate for this risk. | | | | they are sold. |
| A bond mutual fund does not have a fixed | | | | Clearly, to assume that your bond mutual fund is |
| maturity. It does, however, have an average | | | | guaranteed is a misplaced perception. And I must |
| portfolio maturity-the average of all the bonds' | | | | say, over the years, I've spoken with countless |
| maturity dates in the fund's portfolio. In general, | | | | bond mutual fund investors who in fact believe |
| the longer a fund's average portfolio maturity, the | | | | that their underlying investment is guaranteed. It |
| more sensitive the fund's share price will be to | | | | is not. |
| changes in interest rates and the more the fund's | | | | In conclusion, as with any investment it is critical |
| shares will fluctuate in value. | | | | to understand what you own. If you have |
| With respect to interest rate risk, using US | | | | concerns about the structure of your portfolio |
| government bonds as an example, is it possible or | | | | please educate yourself and/or speak to your |
| even likely that interest rates in the US ultimately | | | | financial advisor so that you are certain that you |
| move higher due to the magnitude of US | | | | understand the overall risk of your portfolio. More |
| government debt? In other words, will investors | | | | often than not, investors don't fully understand |
| ultimately demand higher interest rates? Will the | | | | what they own and that, in and of itself, is a |
| Federal Reserve deliberately raise rates as the | | | | reason to be concerned. Further, as investors |
| economy improves? Any "force "that causes | | | | poured money into bond funds in 2009 history |
| interest rates to move higher will be a negative | | | | suggests that their timing may be ill placed and |
| for the prices of bonds. (Information from | | | | therefore they may be setting themselves up for |
| Investment Company Institute brochure published | | | | disappointment. |
| 2006) | | | | Opinions expressed are those of Douglas Adler |
| Credit Risk | | | | and are not necessarily those of Raymond James. |
| Credit risk refers to the creditworthiness of the | | | | All opinions are as of this date and are subject to |
| bond issuer and its expected ability to pay | | | | change without notice. |
| interest and to repay its debt. If a bond issuer is | | | | Past performance is not a guarantee of future |
| unable to repay principal or interest on time, the | | | | results. There is no assurance that these trends |
| bond is said to be in default. A decline in an | | | | will continue. |
| issuer's credit rating, or creditworthiness, can | | | | |