Are you looking for a fixed-income investment? Discouraged by the low yields of money market accounts and bank CDs? Be cautious when joining the flood of investors pouring money into bond mutual funds and buying intermediate-to long-term bonds for their yield. They may be in for a rocky ride when interest rates begin to rise.

The recent increase in bond investments is sobering
Investors must understand that bond returns of the previous 12 to 18 months are unsustainable over the long term. The Wall Street Journal calls the 2009 rally “one of the greatest bond rallies in history.” According to the Bank of America Merrill Lynch Indexes, in early April high-yield bonds were up over 82% from their December 2008 bottom, and ­corporate debt was up over 35% from December 2008.

 Recent strong inflows of cash into mutual funds included $377 ­billion in 2009 alone, according to Morningstar. Of that amount, $357 billion went into bond funds – more than the amount over the previous five calendar years combined. Intermediate bond funds, (particularly those that track the Barclays Capital U.S. Aggregate Bond Index) were the ­primary beneficiaries of these flows.

The Federal Reserve recently ended its $1.2 trillion buying program for mortgage securities, which many believe helped to artificially inflate the prices of agency, corporate, and ­mortgage-backed securities. As 75% of the index is comprised of these types of bonds, investors stand to lose principal as demand weakens and prices decline.

Understand the risks
While low yields on other investments explain some of the cash inflows, other factors (such as investors chasing bond fund performance) are certainly at play. Two key concepts necessary to understand the risks involved are (1) the inverse relationship between bond yields and prices, and (2) duration. As interest rates rise (which appears likely later this year or early next year), existing bonds become less valuable than new bonds. So to fall in line with current bond interest rates, demand for them declines, pushing market prices down and yield up.

As market prices of existing bonds decline, investors that paid a premium to par for individual bonds and invested in funds that hold premium-priced bonds will see depreciation in principal. Thus, while they may be receiving a higher coupon, principal depreciation will reduce their total return. When interest rates decline, the reverse applies.

Duration measures the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates, and is expressed as a number of years. The bigger the duration number, the greater the interest rate risk. According to Morningstar for example, the Vanguard Total Bond Market Index fund has an average effective duration of 4.5 years. So a 1% rise in interest rates would result in a 4.5% decline in prices of the bonds in this portfolio.

High-quality bonds with longer maturities are most at risk
Bonds with longer maturities and higher quality (like Treasuries and government-backed securities) generally bear the greatest interest rate risk. Given their recent greater ­concentration in the index than usual, investors might be in for a big surprise when interest rates begin to rise. Like market corrections we’ve seen in the past, this will likely happen quickly, leaving investors wondering what happened. For example, in 1994 when the Federal Reserve began one of the most aggressive rate increases in the past 20 years, the index lost about 6% between February and mid-May.

Skittish investors are likely to worsen the situation
Investors who don’t have realistic expectations about bond fund volatility might sell quickly, leaving a flood of issues available on the market, which will depress prices even more. When the bond market experienced a ­significant downturn in 1999, bond funds saw outflows that totaled $57.8 billion from September 1999 through December 2000.

In summary, be aware of the risks of investing in bonds and bond mutual funds. Rather than chasing higher yield by buying longer term maturity bonds, focus your fixed income investments on short term securities. If you want to preserve principal, be prepared to accept lower yields.

© 2014 Schenck SC