Many investors were concerned last month that a downgrade in the US credit rating would cause interest rates to rise and bond values to fall. Standard & Poors lowered the credit rating on US government debt but interest rates fell and bond prices rose. Go figure. The net result was a big inflow of money into bond funds as investors dumped stocks for the perceived safety of bonds. The Investment Company Institute reported that bond funds had net inflows of $73.16 billion for the calendar year of 2011 through July 31st.
We believe that it is better to own individual bonds than bond funds (see Is Your Fixed Income Really Fixed). However, if you invest in bond funds, here are three things to check:
Leverage – Some bond funds use leverage to increase yield. The fund borrows short-term to invest in longer term bonds with higher yields. This works well when interest rates are falling. However, rising interest rates cause the bonds in the portfolio to drop in value while raising the cost of the borrowed money.
Derivatives –Derivatives are just another form of leverage. It allows the bond fund manager to potentially increase the portfolio yield. Rising interest rates can cause a lot of damage to bond funds with a lot of derivative exposure.
Foreign Bonds – Fund managers often look for foreign bonds with better interest rates than in the US. This strategy works well when the US dollar is weak but can backfire if the dollar strengthens. The dollar has been weak for some time because of US debt concerns. However, most foreign countries have had their own debt problems. Foreign bonds could lose value fast if the dollar turns around.
These are but a few of the ways bond fund managers try to improve the yield on their funds. They know that a lot of investors look only at the dividend yield to decide which bond fund to buy. A juicy dividend yield could mask a lot of risk in the fund that could ultimately hurt the value of your original principal.