Buying bonds at today’s microscopic or negative interest rates pose extraordinary risks to one’s wealth, but buying certain Exchange Traded Funds and open end funds that own bonds is even riskier. From Wolf Richter, at wolfstreet.com, and David Eifrig, at dailywealth.com:
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.
http://wolfstreet.com/2015/05/20/are-these-ticking-time-bombs-in-your-portfolio/
To continue reading: Are These Ticking Time Bombs In Your Portfolio?
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