Bond Funds Explained – Safe Investments for 2014?

If you feel clueless and invest money in bond funds, you should know that your funds could bite you in 2014. Bond funds are NOT safe investments and some are riskier than others. Read this before investing money (or more money).

Truly safe investments pay interest and your principal is safe, or fixed. Safe investments do not fluctuate in price or value, and may be insured or even guaranteed by an agency of the federal government. Examples include: bank savings and checking accounts, CDs, and Treasury bills. Bond funds pay interest too, in the form of dividends. Their price or value DOES fluctuate as the prices of the debt securities (bonds) they hold in their investment portfolio fluctuate (like stocks). People invest money here to earn HIGHER INTEREST INCOME vs. truly safe investments. That’s why they are also called income funds.

Bond funds are RELATIVELY safe investments – compared to stock funds. But they are not even close to being as safe as money market funds, whose share price is fixed at $1 per share. You must understand this before you invest money in income funds: your investment can go up in value, and it can go down. Some funds invest money (yours) in high quality debt securities of government entities or corporations; others opt for the higher yields of lower quality or even junk bonds. In 2014 and 2015: that’s not the big issue.

While money market funds invest your money in very short-term IOUs, bond funds buy and hold relatively long-term debt securities (IOUs called bonds). A money market fund may hold IOUs that mature (on average) in 25, 30, or 40 days. In other words, they invest money in high quality IOUs that promise to pay them their money back in a matter of days. Because the debt securities held in money market funds are so short-term in nature their value fluctuates little, and they are considered to be safe investments. Not so with income funds that invest money in IOUs maturing (on average) in 5, 10, 15, 20, or more YEARS.

The major issue in 2014 and beyond for bond funds is called “interest rate risk”. Picture a fund that holds IOUs that (on average) mature (pay the owner back) in 20 years. If these are IOUs for $1000 that promise to pay 3% per year in interest ($30) they have a price (or value) of about $1000 when 3% is the prevailing rate for similar IOUs in the bond market. Remember that bonds trade in the bond market just like stocks trade in the stock market. Now, what would happen to the price (value) of this IOU if prevailing interest rates climbed to 6%, 7% or higher?

Investors in the marketplace would still be buying and selling this IOU… but the price of it would fall significantly… because now investors can get 6% or more ($60 a year or more in interest) in other IOUs because that’s the prevailing interest rate. This is an example of interest rate risk in action, and that’s why bond funds are not safe investments. If you invest money in these income funds or plan to, you must understand this.

All income funds will include a number (expressed in years) in their literature called AVERAGE MATURITY. Examples: 3.42 years, 7.15 years, 18.7 years. From left to right these three examples would be called short-term, intermediate-term and long-term bond funds. As you go from left to right the dividend yield (interest earned and paid in dividends) increases. More importantly, the interest rate risk increases dramatically as you go from short-term to long-term funds!

Short-term funds are relatively safe investments, but in today’s interest rate environment they offer miserly interest income. Long-term bond funds might yield 3% or a bit more (depending on quality), but interest rate risk is HIGH. Intermediate-term funds might yield 2% to 3%, but they still have a significant amount of interest rate risk. If interest rates double or more in 2014 and beyond, investors in longer term funds could see losses of 50% or more.

The last time interest rates soared was in the late 1970s, peaking in 1981. Investors who held long-term bond funds lost almost 50%. Today’s interest rates are near all-time lows. This means that when you invest money in longer-term income funds just to earn 3% or 4% in interest income, you are accepting considerable risk to earn a miserly income.

Bond funds have basically been good investments since 1981… because interest rates were falling, which increases the value (price) of these funds. Now, you know the rest of the story. Bond funds are not really safe investments for 2014 and beyond. Interest rates could go up.

401K and IRA Best Investment Strategy for 2014 and 2015

If you invest money in a retirement plan on a regular basis the best investment strategy for 2014 and 2015 is an investment strategy that will keep your investment portfolio on track without subjecting you to a lot of risk. Most of the investment options in a typical 401k and many IRA plans are mutual funds. To achieve long-term growth with only moderate risk you need to invest money in both stock funds and bond funds. What’s your best strategy for 2014 and beyond?

After 30 good years bond funds will turn sour when interests rates turn around and go up (that’s the way bond funds work). Stock funds have returned well over 100% since early 2009. Interest rates are near all-time lows, and an abrupt reversal in rates could cause havoc in both fund categories, resulting in big losses for investors in 401k and IRA plans. It’s time to get proactive to protect your retirement assets.

The best investment strategy for average long-term investors traditionally focuses on a mix of stock funds and bond funds. Picking the best stock funds and best bond funds to invest money in from your list of options is a secondary consideration. Concentrate instead on asset allocation and investment strategy. In other words, how do you spread your money across the different options offered and what kind of strategy do you use to make sure you stay in a position that fits your risk profile? We’re talking money management here, and we’re talking about your financial future.

Let’s say that you consider yourself a middle-of-the-road investor. You are willing to accept moderate risk in pursuit of higher than average returns. Wall Street has traditionally suggested that the best investment strategy is to invest money with about 60% in stock funds and 40% in bond funds. To protect yourself against the possibility of heavy losses in the future, why not get more conservative with your asset allocation?

In a 401k plan asset allocation is your responsibility and you must make decisions on two levels. First, for the investment assets you already have in place (your portfolio allocation). Second, for the new money you invest each payday (your contribution allocation). These allocations can both be the same, or they can be different. For example, upon review of your statement you might see that 70% of your portfolio assets are in stock funds, with 30% in bond funds. And you have 50% of your new contributions going to each.

Here’s my suggestion for the best investment strategy for cutting your risk while keeping stock and bond funds an integral part of your investment mix. No matter what your portfolio allocation is now, change it so that you have equal amounts invested in these three areas: stock fund(s), bond fund(s), and a safe investment option. If your 401k offers a STABLE ACCOUNT option that pays a decent interest rate, use it as your safe option. If it doesn’t, go with the money market fund. Remember, interest rates are extremely low, so money market funds presently pay very little interest. On the other hand, some 401k stable accounts pay higher interest rates than you’ll find anywhere else.

For your allocation for new contributions set it up the same way with one-third going into each of the three options. If you have an IRA that you intend to contribute to on a regular basis, have it set up so that money automatically flows from your bank account to your IRA account. Split the existing money in your IRA into the same three areas as above, and set it up so that equal amounts flow into a money market fund, stock fund, and bond fund each month.

The above strategy will not be the best investment strategy vs. the traditional 60%-40% strategy if both stocks and bonds continue their winning ways in 2014 and beyond. You have traded higher growth potential for greater safety. If, on the other hand, interest rates rise significantly and throw a wrench into the stock and bond markets, this investment strategy should work to your advantage.

Let’s say that stock funds and/or bond funds decline significantly in value for a couple of years or more before rebounding. My suggested strategy has two primary advantages. First, your losses will be lower. Second, the new money you have flowing into stock funds and bond funds each month or each payday will buy more and more fund shares as fund prices get cheaper. When prices rebound you will break even and start to show a profit sooner because you bought stock funds and bond funds at cheap levels. That’s called dollar cost averaging… which is a crucial part of the best investment strategy.

Sometimes the best investment strategy is to take aggressive action – like after a major decline in stock prices. Other times the best strategy is to be more cautious by cutting the risk in your portfolio… while you continue to invest money in stock funds and bond funds. In 2014 and beyond, I believe that caution is your best strategy.