If there is a bond bubble and it bursts, will the bond funds go bankrupt? Here’s a “notice” for the millions of bond fund investors. These fixed income investments may not be the safe investments you think they are.
The funny thing about bubbles in financial and other markets is that few investors know about them until they burst. Think: the stock market bubble of the year 2000 and real estate in 2007/2008. With 2010 drawing to a close, talks about a bond bubble emerged. Bond funds and real estate used to have one thing in common. People generally considered them good safe investments. Few people feel this way about real estate anymore, so let’s take a closer look at bonds and bubbles. Are Bond Funds Really Safe Investments Today?
A bubble in any market simply refers to excessively inflated prices. The lousy stock market and low interest rate environment of the new millennium made real estate the investment of choice to earn big bucks. Trading properties at higher and higher prices became a game that most people could play with almost no money. Many houses doubled in price in less than five years. Enter … the financial crisis and the bursting of the housing bubble.
What you need to understand today is that there is a bond market where these securities are traded, and bond prices are determined in much the same way as stock prices in the stock market. In other words, the price or value of the bonds will fluctuate as investors buy and sell them on the market. Bond funds simply hold and manage a portfolio of these fixed income investments for their investors. So if you own stocks in a bond fund, you are invested in bonds; which are not really safe investments. The value of your investment can go up or down.
To handle things, let’s take a look at an example of a typical bond. Think of it as a long-term note issued and sold to investors by a government entity or corporation to borrow money. The issuer sells to the public a $ 1 billion worth of $ 1000 bonds that mature in 2035 and pay 6% annual interest. Each year, the bond owner is promised $ 60 in interest on this $ 1,000 investment through 2035, and this $ 60 never changes. In 2035, the bondholder (which could be a mutual fund) recovers the $ 1,000 in equity and the investment ceases to exist.
Does this mean that you should keep this investment until 2035? No, that’s where the bond market comes in. Once the bond is issued and sold to investors, it begins trading on the bond market, where any interested investor can buy or sell it. The 6% interest rate will never change, but the price will fluctuate as it is traded over time. Imagine this bond trading for more than $ 1000 while interest rates continue to fall to the point that a one-year certificate of deposit pays less than 1%. Investors are struggling to buy it and are willing to pay higher and higher prices to own this and other bonds with attractive interest rates. That is what has driven bond prices to historically high prices and why there is talk of a bond bubble.
If this trend continues and reaches extremes, you have a bubble that is about to burst. If investors feel that the interest income from the bonds and bond funds no longer justifies the risk of holding these investments, they will start selling. If they rush out, the bond bubble bursts. Bond funds might not fail, but they would lose significant value. Those most affected would be long-term funds with bonds that mature in 15 years or more. So, notice. Don’t ignore your bond investments and pay attention to the bond market.
If a bond bubble appears on the horizon, there are safe investments you can protect yourself in without leaving your mutual fund company. Money market funds pay interest in the form of dividends and do not fluctuate in value like bond funds do.
