One Way to Avoid a 4th Of July Bond Hangover

In May 2013, mutual funds that buy bonds from the US government lost, on average, 7 percent. In other words, if you invested $10,000 for 10 years in one of those mutual funds, you now have about $9,300. You lost around $700 in one month.

In May, bonds got hammered.

Bond funds that loan money to companies, like Apple, also tanked.

Remember, buying a bond is just giving out a loan and receiving interest in the meantime.

Apple bonds were down almost 10 percent in May.

Bonds got hammered.

Why Did This Happen to Bonds?

The Fed has been trying to stimulate the economy by keeping interest rates low. Interest rates, meaning, 1) the Federal Funds Rate (interest rate that banks charge to lend each other money over night, set by the Fed), and 2) interest rates you pay on your mortgage.

Keeping these interest rates low are supposed to help the economy grow.

But now people think the Fed won’t keep interest rates low because the economy has been improving.

And, an increase in interest rates hurts existing bondholders since new bonds will pay a higher interest rate, while you’re stuck with old bonds that pay a lower interest rate.

So people have been selling bonds before the Fed has even announced they’re going to increase interest rates. Bonds had their largest weekly outflow ever, recently. In case you forgot……

Bonds got hammered.

How to Avoid a Bond Hangover

Interest rates on 10-year US government bonds increased by almost 30 percent in May. Basically, the interest you’d receive for loaning the US government money today (aka investing in a US 10-year government bond) increased by 30 percent.

But that’s if you’re buying a 10-year US government bond right now. If you bought it before May 2013, you’re stuck with the old *lower* interest rate, so the value of your bond actually went down.

While interest rates have gone up recently, rates are still near record lows. So there’s more room for them to go up than down, and you’ll continue to lose money on your existing bond investments if interest rates continue to increase.

One Way to Avoid a Bond Hangover

In case you missed the entire point of this article, most bond funds lose money when interest rates rise.

But, there are bond funds that make money when interest rates rise.

Wait, what?

Yes. These are called opportunistic bond funds. They’re sometimes called absolute return bond funds, unconstrained bond funds, or flexible bond funds.

These funds do three main things for you:

1) They can short bonds so they actually make money when interest rates go up.
2) The interest rate sensitivity of the bonds they invest in is low, and sometimes even negative (interest rates go up and they actually make money).
3) They’re typically “actively managed” (i.e. non index funds or non-ETFs) so they can rotate into positions that benefit from rising interest rates (long-term US government bonds) if need be, like in 2008.

Pimco and JP Morgan offer unconstrained bond funds as do many other firms, but I’m not telling you to invest in their funds. (You sue me, you die. Write that down.)

There are also funds (ETFs and index funds) that take outright short positions in long-term US government bonds, like TBT. I’m not telling you to buy that fund. (You sue me, you die. Write that down).

Now for the risk. The obvious risk with this type of an investment is a declining interest rate environment. These types of strategies will most likely lose money if interest rates decrease a lot, like in 2008.

TBT lost its ass in 2008, the fund was down almost 50 percent — this is because it is a “short only” fund.

The “flexible” funds (point #3 above) didn’t lose any money or were down 1-2 percent because they had “some” exposure to bonds that make money when interest rates decline. There’s a big difference between short only bond funds and flexible bond funds.

You will continue to see more and more of these unconstrained/flexible bond funds launch in the coming months and years. Some are worth taking a close look at and some are not (like funds with front-end sales fees of 5 percent).

I do not own any long-term US government bond funds. I own one flexible bond fund in my 401(k) — simply because, I can’t deal with hangovers.

About the Author:
Kathryn Cicoletti is Writer and Founder of The Money Site For Non-Finance People. Finance People Are Annoying.

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