I have on occasion warned about bond funds. Bonds themselves can be a great investment – and have largely been a great investment over the last 30 years, running up all the way to the peak of the greatest credit bubble in history.
If the bond market starts throwing up, you can always hang on to your bonds, collect the interest, and get out alive. If the company gets knocked over and it “restructures,” stockholders get wiped out, but depending on what kind of bond you hold, you could be made whole, lose part of your capital, or get wiped out too.
The yield is supposed to compensate for these and other risks, though it hasn’t in years, thanks to the Fed’s interest rate repression.
Bond funds are an entirely different animal. Not all bond funds are made of the same cloth. But anyone holding the Schwab Yield Plus Select fund (SWYSX) in 2007 and 2008 knows this. Like most bond funds, it was an “open end” fund (more on this kind of monster below). It was stuffed to the gills with highly rated mortgage-backed securities. It looked great on paper, at one point had $13 billion in assets, and paid half a percentage point more in yield than a 1-year FDIC insured CD.
When cracks appeared in the credit markets in 2007, some investors pulled their money out. So for them, the low-yield gamble – that’s what it was – worked.
After them, the deluge. Soon everyone was pulling their money out. At first, the fund sold its most liquid assets, such as Treasuries, and didn’t show any significant losses. When it ran out of them, it had to sell other bonds, but there weren’t many takers, and it had to sell them below their book value. Losses appeared. As they got worse, investors woke up, and the fund experienced an all-out run and had to dump its MBS for which liquidity had dried up – for cents on the dollar.
At the other end of every bond fund sits the “smart money,” waiting for the opportunity. And the “smart money” bought these MBS and later sold them to the Fed at a huge profit. Investors in SWYSX got cleaned out. Those who sat it out to the end, hoping for the uptick, lost well over 50% before it was eventually shut down.
Lawyers – class-action types and those representing individual investors – had a field day. Schwab paid out a chunk of money to settle these suits, and much of it went to the lawyers.
It was a little extra yield for a ton of extra risk.
That’s the theme today as well. But now bond funds are stuffed with junk bonds. They can get ugly in a hurry too.
Unlike investors who hold bonds outright, investors in “open-end” bond funds that experience a run can’t benefit from an eventual uptick in bond prices – because the fund is forced to sell them at the worst possible moment!
Few funds actually go through a real run like this, but when they do, it’s bloody for the small fry and a huge opportunity for lawyers and the “smart money.”
So here are the salient parts of an article by David Eifrig on what constitutes a “time bomb in your portfolio” – given the current climate – and what might be an acceptable risk….
By David Eifrig, Daily Wealth:
Fixed-income securities – specifically bonds – are an important part of any balanced portfolio. You put your money into a bond and lock up a certain yield. Then, you get paid year after year for loaning the bond issuer your money. That’s why bonds are considered a safer way for retirees to earn a return on their savings, rather than being exposed to the ups and downs of the stock market.
The thing is, not all bond investments are the same.
Over the years, I’ve talked a lot about the differences between open-end funds and closed-end funds (you can read my educational interview on the subject here). Most of the funds folks are familiar with are open-end funds, like the traditional mutual funds you might own in a 401(k) or exchange-traded funds (ETFs) you might own in an IRA.
“Open-end” means the fund will issue as many shares as investors are willing to buy. When investors put more money into the fund, the fund issues more shares and buys more of the underlying asset – in this case, bonds.
Conversely, when investors pull money out of an open-end fund, the fund must liquidate shares and sell off the underlying asset to give shareholders their money back. This is precisely what makes open-end bond funds so dangerous today.
You see, the beauty of fixed-income investments, like bonds, is that you can buy them (individually) and then hold to maturity, collecting the interest payments along the way and the principal repayment at the end. But that only works if you have a long-term view and personal control of the portfolio.
Bond prices fluctuate, so if you trade in and out of bonds, you can take losses at the wrong time.
That’s what happens when a lot of investors in open-end bond funds want their money back at the same time… The fund managers have to sell some of the bonds they hold to raise cash and repay investors. With the selling, the prices of the bonds drop. Then, shareholders of other mutual funds see the prices dropping and demand their money back, too. And suddenly, it’s a scramble for the exits.
Unlike an individual, open-end funds don’t get to hold and collect their bond payments until maturity. If shareholders want money, they have to sell whatever they have to raise the funds.
So even if you are a long-term investor, your fund manager might not have that luxury. That’s why we hate open-end funds.
Even worse is that these kinds of funds are so common. According to the 2015 Investment Company Fact Book, $15.9 trillion of the $18.2 trillion of assets held at U.S. investment companies is in the form of open-end mutual funds. Another $2 trillion is held in open-end ETFs.
According to the same report, open-end bond mutual funds experienced net inflows of $44 billion, last year alone. Since 2005, bond mutual funds have received $1.9 trillion in net inflows and reinvested dividends. And that’s not even factoring in the inflows to bond ETFs.
When all this money starts scrambling for the exits, it’s not going to be pretty.
For this reason, we prefer closed-end bond funds that don’t have to sell to redeem investor money. As I mentioned, when closed-end-fund shareholders want their money back, they simply sell those shares to another investor (like a traditional stock). That transaction has no bearing on the capital available for the fund to invest. You can find all kinds of closed-end funds at www.cefconnect.com.
In the meantime, we recommend reviewing your bond-fund holdings and selling all of the open-end funds immediately.
If you’re holding closed-end bond funds, the ride could still get rough. Prices can still go down. But know that the fund won’t have to sell its holdings because the price is dropping. And if rates do explode upward (which we think is unlikely), the closed-end-fund manager can use maturing bond funds to buy new higher-yielding bonds. This is a win-win for closed-end-fund bond holders.
Just make sure they aren’t leveraged bond funds of any type – that will get ugly when rates go higher. By David Eifrig, Daily Wealth.
But the Fed that has created the greatest credit bubble in history has “almost no credibility” about “staying on top of a ticking monetary bomb.” Read… Former Fed Governor Predicts “Wrenching” Market Adjustment