It is a common belief among investment professionals from all walks of life that bonds are safer investments than stocks. This is why most financial advisors will generally recommend that an individual increase the proportion of their portfolios that is allocated to bonds as they age. While it is true that holding a high-rated bond to maturity is generally a safer investment than holding any individual stock, the same cannot be said of bond funds. These funds suffer from a variety of problems, at least currently, that may make them inappropriate for an individual that is either in or nearing retirement (or anyone else for that matter).

Interest Rates

Since the early 1980s, bonds and bond funds have consistently delivered capital gains, which may have led some investors into these funds hoping for more of the same. Unfortunately, this is unlikely to be the case. This is because bond prices move inversely to interest rates. Wells Fargo explains this relationship thusly,

When new bonds are issued, they typically carry coupon rates at or close to the prevailing market interest rate. Interest rates and bond prices have whats called an `inverse relationship - meaning, when one goes up, the other goes down. The question is: how does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else? The answer lies in the concept of `opportunity cost.

Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bonds coupon rate - which, remember, is fixed - becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself.

Wells Fargo provides an example to illustrate this concept, which I will share here as it is quite useful to aid understanding:

Suppose the ABC Company offers a new issue of bonds carrying a 7% coupon. This means [that] it would pay you $70 a year in interest. After evaluating your investment alternatives, you decide this is a good deal, so you purchase a bond at its par value, $1,000.

What if Rates Go Up?

Source: Wells Fargo

Now lets suppose that later than year, interest rates in general go up. If new bonds costing $1,000 are paying an 8% coupon ($80 a year in interest), buyers will be reluctant to pay you face value ($1,000) for your 7% ABC bond. In order to sell, youd have to offer your bond at a lower price - a discounts - that would enable it to generate approximately 8% to the new owner. In this case, that would mean a price of about $875.

An individual who is aware of this simple relationship can easily identify the cause of the bond bull market that prevailed for the past 35 years as well as the reason why bonds and bond funds delivered such strong capital gains over that period. That cause is interest rates. Since the early 1980s, when the Federal Reserve set interest rates in the double digits (in December 1980, the Federal Funds rate was 18.5%), the Federal Reserve has been steadily decreasing interest rates (the Federal Funds rate today is 0.14%). Due to this inverse relationship between bond prices and interest rates, this has caused bonds to steadily appreciate, resulting in capital gains for bond investors.

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Source: Federal Reserve Bank of St. Louis

Unfortunately, the steady decline in interest rates has made it highly unlikely that any further capital gains will be forthcoming. This is because interest rates cannot go measurably lower than todays levels. At its most recent meeting, the Federal Reserve decided to maintain its target Federal Funds rate at 0-0.25%. This is the lowest level possible without allowing interest rates to go into negative territory (which has happened in a few European countries recently, but even then the rates did not go significantly below zero). Therefore, the likelihood of further capital gains is minimal. Meanwhile, should rates ever begin to increase, then all bonds will begin to decline in value.

This may not be a problem if an investor purchases an individual bond and holds it to maturity. This is because, barring a default, the par value of the bond will be returned to the investor at maturity. Thus, fluctuations in value are nothing to be concerned with. However, a bond mutual fund is very different. An investor in the fund has no control over whether or not the fund sells any particular bond and given the current interest rate environment, it is quite likely that the bond will be sold at a loss (once interest rates begin to turn). Furthermore, should bond prices decline, then the NAV of the fund will also begin to decline. This may prompt some investors to leave the fund, forcing the fund to sell bonds in order to meet these redemption requests. Due to the pooled nature of mutual funds, the losses will be spread over all investors in the fund.

Illiquidity

On Tuesday, September 22, 2015, The Wall Street Journal published an article entitled, Bond Funds Push Limits. In this article, the Journal discussed how several of the largest mutual funds in the country have a relatively high proportion of their assets invested in bonds that trade so infrequently that it would take much more than seven days to sell them should the fund need to raise cash to meet redemption requests. For example, the Dodge amp; Cox Income Fund (MUTF:DODIX) has $496 million, or 1.1% of the fund, invested in debt backed by Petrobras (NYSE:PBR) that would require 155 days to liquidate should the fund need to.

This is problematic for investors for a few reasons. First and foremost is the fact that retail investors tend to move in herds. Thus, should the NAVs of these funds begin to decline, it is quite likely that redemption requests will increase rapidly, exceeding the ability of the funds to meet these requests solely with cash on hand. This would force the funds to sell their assets to fulfill these requests and as already mentioned, many of the bonds owned by these funds will take a considerable amount of time to dispose of. In fact, 10 of the 18 largest bond funds invest meaningfully in these bonds. Here are a few of the biggest offenders:

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Source: The Wall Street Journal, Morningstar, MarketAxess

As the Journal points out, the funds may still be able to liquidate their illiquid assets quickly if they need to. However, in order to do this, they will need to heavily discount the bonds, resulting in significant losses for those investors who remain.