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Bond Funds Explained: Safe Investments for 2014?

If you are 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 their 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 also pay interest, in the form of dividends. Its price or value fluctuates as the prices of the debt securities (bonds) that you have in your investment portfolio (such as stocks) fluctuate. People invest money here to earn HIGHER INTEREST INCOME vs. truly safe investments. This is 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 set at $ 1 per share. You need to understand this before investing money in income funds – your investment may increase in value and it may decrease. Some funds invest money (yours) in high-quality debt securities of government entities or corporations; others opt for higher yields on lower-quality bonds or even junk. In 2014 and 2015: that’s not the big problem.

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

The main problem in 2014 and beyond for bond funds is called “interest rate risk.” Imagine a fund that has notes that (on average) mature (return to the owner) in 20 years. If these are $ 1,000 notes that promise to pay 3% per year in interest ($ 30), they are priced (or valued) of approximately $ 1,000 when 3% is the prevailing rate for similar notes in the bond market. Remember that bonds are traded on the bond market just like stocks are traded on the stock market. Now, what would happen to the price (value) of this note if the prevailing interest rates rose to 6%, 7% or more?

Investors in the market would keep buying and selling this note … but the price would drop significantly … because now investors can get 6% or more ($ 60 a year or more interest) on other notes because that’s the current interest rate. This is an example of interest rate risk in action, and that is why bond funds are not safe investments. If you are investing money in these income funds or planning to do so, you need to understand this.

All revenue 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, medium, and long-term bond funds. As you move from left to right, your dividend yield (interest earned and paid in dividends) increases. More importantly, interest rate risk increases dramatically as you move from short-term funds to long-term funds!

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

The last time interest rates skyrocketed was in the late 1970s, peaking in 1981. Investors with long-term bond funds lost nearly 50%. Today’s interest rates are near record lows. This means that when you invest money in longer-term income funds just to earn 3% or 4% in interest income, you are taking considerable risk for measly income.

Bond funds have been basically good investments since 1981 … because interest rates were falling, increasing 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.

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