There was a time when owning the best bond funds wasn’t that important, but if you don’t own the best bond funds in 2015 and beyond you might not want to own any at all. For many years these income producing funds were considered to be relatively safe investments, and they proved to be good steady performers as well.
These funds are also called INCOME FUNDS. Their objective: to produce higher interest income, as relatively safe investments. When you invest in them you own a very small part of a very large portfolio of FIXED INCOME debt securities called “bonds”. We are going to keep it simple here in order to drive home the most important thing you need to know about them: in 2015 and beyond even the best bond funds will not be safe investments.
Back in 1981 interest rates peaked at all-time highs and then declined for many years, recently hitting record lows. The fixed income produced in income fund portfolios became more and more attractive vs. prevailing rates. The result was: good dividend income and RISING SHARE PRICES for fund owners. You didn’t need to own the best bond funds. A rising tide lifts all boats.
For a good number of years the average income fund outperformed the average stock fund… and unlike stock funds… they did not hand investors big losses every few years. No wonder millions of investors became devoted fans of these funds and still view them as good safe investments. Why should you be concerned about owning only the best bond funds in 2015, 2016 and beyond?
Look at today’s interest rates. You’re lucky if you can get interest income of 1% on a one-year CD or dividend income of 3% from a quality income fund. In 1981 you could get 15% on the CD and from an income fund. Today, in order to net over 3% in dividend income from bond funds you’ve got to either opt for junk quality or own a long-term fund; and the average conservative investor does not want to own junk (low quality) funds because they are definitely not safe investments. Note: fixed long-term debt has a higher interest rate due to the risk related to the time factor.
You’ve seen how income funds behave when interest rates are falling, but I didn’t tell you this: the best bond funds when interest rates are falling are long-term funds. After all, their portfolios hold higher interest rate debt securities that are fixed and locked in for 20 or more years. Now, you ask, what happens if interest rates go up?
When rates go up you are looking at the flip side of the coin. Even the best bond funds will LOSE MONEY, but long-term funds could get massacred. That’s not just likely; it’s the way the world of finance works. When rates peaked in 1981 long-term funds approached losses of 50%. In other words, not even the best bond funds are truly safe investments.
The primary concern for investors in 2015 is “interest rate risk”. When rates go up, income fund investors will lose money. Don’t be overly concerned about quality (but avoid junk). Be very concerned about the average maturity in a fund’s portfolio (long-term vs. shorter term). Avoid long-term funds. The best bond funds for 2015 are called intermediate-term funds, and their portfolios hold securities maturing in 5 to 10 years. Look for one with an average maturity of about 7 years. While these aren’t really safe investments, they have much less interest rate risk than long term funds.
The best bond funds also have low costs and expenses; and no sales charges called “loads”. Most people should hold income funds to give their total portfolio balance. In 2015 and beyond go with the best bond funds to keep your overall risk at acceptable levels.