One of the first things an early or new investor is typically told is that bonds are safer than stocks but will offer lower capital appreciation than stocks. Or in simpler terms, bonds are less risky, and, therefore, they offer a lower reward. But in reality, these things we are taught about a bond's risks are not always true, depending on how you are invested in the bond, bonds, or a bond ETF.
Most people speak of the risk profile when they are talking about low risk. Low reward bonds is a scenario when the investor holds the individual bond themselves. Like stock ownership, a bond investor can buy individual bonds and hold them in their portfolio.
Let's quickly look at how and why bond prices change before we go any further. Say you buy a 1-year bond for $980.00, and when it matures in a year, it will be worth $1,000, meaning the bond you bought is yielding a 2% rate of return. Now let's say you hold the bond for the full year; you will make your 2% or $20 and be happy. Your only risk in this scenario is that whoever sold you the bond defaults on it, which for this example, is probably not likely. (The higher the interest rate on the bond at the initial time of sale typically indicates how risky the bond is and how likely the bond seller is to default. 2% is a very low risk in normal market conditions.)
If you plan to hold and ride the bond to mature, bonds are very low risk, as we have all been taught. However, if you plan to sell the bond before maturity, you are increasing your risk. For example, when you own the bond we spoke about above, that is paying a 2% rate of return, if the current market is demanding say a 4% rate of return on bonds, then to sell your bond, which you paid $980 for, you would have to offer another investor a 4% rate of return, or sell the bond at $960, so the buyer could realize a 4% rate of return, which is the current going rate for a bond if they held the bond to maturity.
Now the flip side is also true. If you paid $980 and got a 2% rate of return, but bond yields fall to 1%, you could sell your bond at $990, offering the new buyer the 1% rate of return, which is what the market is commanding at the time.
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So, when bond interest rates fall, current or older bonds with higher interest rates are more valuable. But when bond prices increase, current or older bonds that now have lower interest rates than what new bonds are being offered will fall in value. However, in all scenarios, if you just hold the bond until it matures, you will realize the original interest rate or rate of return you were offered.
Now the points above are key to understanding why you may have bought into more risk than you realized when you bought that bond Exchange Traded Fund. Not all, but most bond ETFs will not hold the underlying bonds until maturity. Therefore, they will likely sell the bond at either a profit or loss, which is already increasing your risk of owning the bond fund.
More so, we know that because of the Federal Reserve, bond prices are currently very, very, very low on a historical basis. This means there is a good chance that interest rates for the bond will go higher in the future, and therefore current bonds will see their value decline as other bonds offer a more attractive interest rate. This is where the risk for a bond investor, who doesn't plan to hold until maturity, is going to be facing in the coming years.
But since you understand what the risks to owning bonds are, now you may have a better idea of how to reduce some of that risk, even though you still may own or want to own bond funds.
We can quickly take a look at three different bond funds and how each may increase or reduce your bond risk.
The first is the iShares Core U.S. Aggregate Bond ETF (AGG). This bond ETF is, in the simplest terms, investing in the bond market. Just like people say that if you buy an S&P 500 ETF, you are investing in the market, buying the AGG is investing in the bond market. It holds a vast array of bonds, and it will give you full exposure to the bond market. This is both a good and bad thing at a time like this because you will be holding old bonds that may lose value if higher rates start hitting the market, but then you will own those higher-rate bonds when they become available. However, I would stay away from this because there is still a lot of interest rate rising risk within the current bond market.
The next is the Vanguard Long-Term Bond ETF (BLV), which invests in long term bonds. Currently, about 70% of the fund holds bonds maturing in 20 to 30 years. 23% of the fund is in bonds maturing in 10 -20 years. This long exposure can be a good thing because the fund likely holds bonds with higher return rates than what is being offered in today's current market situation. That means the bonds this fund holds will not likely lose a ton of value if interest rates go higher. And depending on how high they go, the fund may not lose any value if the bonds it owns are paying a higher interest rate than what the market is offering on new bonds.
Finally, we have the SPDR Bloomberg Barclays 1-3 Month T-Bill ETF (BIL). This ETF only owns U.S. Treasury bonds that mature in 1 to 3 months. This can be a good thing when you believe interest rates will rise because you will not be holding a bond ETF that will be losing value as the bond prices decline. This bond fund likely holds the bonds it owns until maturity or very close to it, therefore not losing a ton of value on the bond price itself. Yes, this fund will not offer a lot of upside potential due to its very short bond holding period and likely corresponding very low-interest rates. However, it will offer very, very low risk.
Bond investing is similar to stock investing in that there are a lot of moving parts. When someone gives you advice, regardless of who it is from, do your research to fully understand the amount of risk you are taking before making a decision. Bonds in one form can be very low risk, but they can be too much for the average bond investor to stomach in another form.
Matt Thalman
INO.com Contributor - ETFs
Follow me on Twitter @mthalman5513
Disclosure: This contributor did not hold a position in any investment mentioned above at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.
Another problem with many corporate bonds is that they are callable before maturity by the corporation. In a falling interest environment many higher yielding bonds could be called (Redeemed) by the corporation at a disclosed price, and the firm can then issue new bonds at lower rates. At any time, if a corporation's financial strength improves significantly, that firm could do the same.
Fools buy Bonds