Bond funds help avoid interest rate risk
Traditional bond funds lost value last year as the Federal Reserve steadily increased interest rates. The Fed could also increase interest rates in 2019, and this causes some concern among bond fund investors.
One of the disadvantages of traditional bond funds in a climate of rising interest rates is that there is no fixed maturity date; fund managers are continually modifying their portfolios. Accordingly, when an investor sells shares of the fund, he or she may face a loss of net asset value (NAV).
There are ways that bond investors can mitigate interest rate risk. The simplest is to buy individual bonds and hold them to maturity. In this way, an investor is sure to receive the par value of the bond when it matures. Laddering bond purchases makes it easier to hold issues to maturity and avoid having to sell in a time of rising rates.
The major disadvantage of holding individual bonds is that it exposes an investor to greater default risk, especially with corporate bonds. An investor could buy U.S. Treasury notes and bonds, but the added security comes at the cost of lower coupon rates.
Benefits of target funds
There is another option for those looking for higher coupon rates, the benefits of diversification and relative protection from interest rate risk: target-maturity bond funds.
These funds hold bonds that mature in the same year. For example, assume you know that you want to invest in bonds for a 10-year period and then liquidate your holdings because you are facing a specific payment, such as college tuition. A target-maturity bond fund allows you to avoid interest rate risk because the bonds held mature at the time you wish to liquidate.
Two financially stable fund families that specialize in this type of investment are Invesco and BlackRock. Both companies issue exchange-traded funds (ETFs).
Invesco invests in corporate and emerging markets with maturities every year up to 2028. BlackRock iShares are invested in corporate and municipal bonds with maturities from 2020 to 2028. These ETFs have modest fees of approximately 0.5 percent per year.
If you invest in traditional bond funds, you can find some funds with lower annual fees. However, as I indicated, traditional bond funds expose you to the risk of selling your shares at a time when the NAV is lower because of unfavorable interest rate increases.
Target fund downsides
Target-maturity bond funds do have some disadvantages. The bonds held in the fund mature in the same year, but some will mature months before the fund’s closing date. The cash associated with the sale of these bonds will be idle and have negligible return.
Another disadvantage is that some of the bonds in the portfolio might be called, and the fund management will not be able to invest these proceeds with high returns.
Another potential disadvantage is liquidity risk: If you decide to sell your shares prior to the closing date you selected, you could be facing some loss in value as there may be insufficient interest in purchasing your shares.
What to do
If you are a short-term bond investor and are concerned about interest rate risk, invest in bond funds with three- to five-year maturities. You will receive reasonable returns with minimum interest rate risk.
If you are a long-term bond investor, then traditional bond funds have advantages over the target-maturity bond funds.
However, if you are pretty certain as to when you need the funds in your bond portfolio, and you are concerned about interest rate risk, then you can consider target-maturity bond funds as an alternative.
© 2019 Elliot Raphaelson. Distributed by Tribune Content Agency, LLC.