Paul Smith, a retired attorney in Oakton, Virginia, lost 30 percent of his 401(k) retirement savings during the financial crisis.
He shifted to bond funds from stocks and now holds at least 60 percent of his retirement savings in fixed income. While payouts from some of the bond funds barely keep up with inflation, Smith said, he’s worried that stocks could see another decline.
“Both my wife and I are very risk averse,” the 64-year-old said in an interview. “Frankly, the volatility in the market is very much a concern to us.”
Investors like Smith have poured $982 billion into U.S. bond funds from January 2008 through August while pulling $439 billion out of equity funds, sacrificing a 115 percent rally in stocks from their lows for the perceived safety of bonds. Money managers and fund executives such as Pimco’s Bill Gross and BlackRock Inc.’s Laurence D. Fink are warning that the flight to bonds leaves savers exposed to a new round of losses once interest rates rise, a risk many retail clients aren’t aware of.
While investors who hold bonds until they mature don’t lose money unless the issuer defaults, mutual funds and other holders who trade the securities to maximize yields can suffer losses if interest rates rise. Long-term Treasuries had almost as many losing years as stocks in the past 85 years, and fared worse than equities by that measure when adjusting for inflation, according to Chicago-based Morningstar Inc.
“The greatest irony here is the perception of safety in a fixed-income security,” said Mitchell Stapley, chief fixed income officer at Cincinnati-based Fifth Third Asset Management. “As the head fixed-income guy here, when I look at bonds today, they scare the hell out of me.”
In 1994, when the U.S. Federal Reserve raised its target rate six times, bond funds on average lost 4.6 percent, according to Morningstar. Investors pulled $62.5 billion from the category that year, compared with deposits into equity funds of $114.5 billion, according to the Investment Company Institute, a Washington-based trade group that represents the mutual-fund industry.
From 1926 through 2011, U.S. long-term Treasury bonds had losses in 22 years, compared with 24 years for stocks. When adjusting for the impact of inflation, long-term Treasuries lost money for investors in 33 years, more than the 28 years for stocks. And while losses in stocks tend to be bigger -- they declined an inflation-adjusted 37 percent in 1931 and 2008 -- the record-low interest rates of the past year have increased the potential for large, abrupt declines in bonds.
In 2009, when stock markets hit their bottom and the economy started to rebound, long-term Treasuries declined 17 percent after adjusting for inflation, their worst year on Morningstar records going back to 1926.
“If interest rates were to rise rapidly there would be significant losses in bond funds,” said Mercer Bullard, associate professor of law at the University of Mississippi and founder of investor advocacy group Fund Democracy. “That can catch a lot of people and hit them with losses they weren’t expecting.”
Ryan Melvey, 21, holds half of his investments in bonds, a $19,000 portfolio that he started at age 16 with about $4,000 he made from busing tables. He was fully invested in equities in 2008 and has since built a portfolio that he believes will perform, regardless of the economy.
“I learned that I never wanted to go through that again,” Melvey, a junior at Seattle University, said of his losses during the financial crisis. “I needed to construct a more diversified portfolio and bonds were going to have to play a role in that.”
Melvey, who recently finished a six-month internship at Amazon.com Inc., has 25 percent of his portfolio invested in Treasuries and another quarter of his assets in the iShares Barclays 20+ year Treasury Bond Fund, an exchange-traded fund. If interest rates were to rise 0.25 percentage point, the ETF may lose 4.6 percent, according to data compiled by Bloomberg.
The extent to which a fund is at risk of losses from rising rates depends on its holdings, Bullard said. In 2009, when long-term Treasuries slumped, bond funds posted gains of about 18 percent as lower-rated debt rallied. Once interest rates rise, shorter duration bonds have a lower risk of losses, he said.
The BlackRock Core Bond Fund, which holds a variety of fixed-income securities, may lose 1.3 percent with the same quarter-point increase in rates, data compiled by Bloomberg show. The Pimco Short-Term Fund, the majority of which is invested in corporate debt, may lose 0.25 percent.
Melvey, a finance major, said he isn’t “too worried” about interest-rate risk, pointing to Japan, which has been in a deflationary phase for more than a decade.
“I’d make the argument that interest rates can remain low for a lot longer than people think,” Melvey said.
The Federal Reserve has supported the bond market by keeping its target rate for overnight loans among banks between zero and 0.25 percent since December 2008 and embarking on three rounds of unprecedented asset purchases. The Fed said on Sept. 13 it will probably keep the federal funds target rate near zero until at least mid-2015.
That helped bonds outperform stocks last year even with borrowing costs near record lows. Bond funds returned an average 6.1 percent in 2011, and stock funds lost an average 5.7 percent, data compiled by Morningstar show. This year the average stock fund has returned 13 percent as of Sept. 30 compared with 6.7 percent for the average bond fund, Morningstar data show.
Managers of some of the largest bond funds have warned rates can’t stay low forever, and investors in bonds may be poised for losses. Gross, manager of the world’s biggest bond fund at Pacific Investment Management Co., said the U.S. must begin to close the gap between spending and debt or inflation will result.
“Bonds would be burned to a crisp,” Gross, whose Pimco Total Return Fund has $278 billion in assets, wrote in his Oct. 2 investment outlook.
Jeffrey Gundlach, chief executive officer of DoubleLine Capital LP, said on Sept. 13 that U.S. Treasury 30-year bonds have “incredible downside.” BlackRock’s Fink, CEO of the world’s biggest money manager, has been urging investors to get back into equities.
Gross has been buying Treasury Inflation Protected Securities, or TIPS, as a way to profit from a likely inflationary situation in the next few years. To account for interest rate risk, Gundlach maintains an allocation to both agency mortgage-backed securities and non-agency mortgage securities, which don’t have an explicit or implicit guarantee from the U.S. government.
Many investors don’t understand what could happen to their bond fund investments in a rising interest-rate environment, which is an issue today because rates are at “rock-bottom,” said Bullard.
Martin Sokol, 75, said he didn’t know until earlier this year that his investments in bond funds may be vulnerable to losses if interest rates rise.
“I only realized that within the last six months,” after reading more about interest rates, said Sokol, who has a family-owned leather company in Queens, New York. “I go by the old adage: whatever your age is, that’s what you should have in fixed income.”
Sokol has about three-quarters of his individual retirement account invested in bond funds through Fidelity Investments and said he’s sticking with that allocation for now. Last year his bond funds returned 6 percent, or more than he could earn from certificates of deposit. CDs are time deposits with banks that generally offer higher interest rates than savings accounts and are insured by the Federal Deposit Insurance Corporation.
The Fidelity Total Bond Fund, which Sokol was invested in as of August, may lose 1.4 percent if interest rates rise 0.25 percentage point. He also put money in the Metropolitan West Low Duration Bond Fund, which may lose 0.46 percent under the same scenario, according to data compiled by Bloomberg.
Losses from bond funds going forward may be worse than at other points in history when interest rates rose, such as in 1994 or the late 1970s, said Ken Volpert, principal and head of taxable bonds for Valley Forge, Pennsylvania-based Vanguard Group Inc. Beginning in 1977, long-term government bonds saw five straight years of losses of as much as 14.5 percent when adjusted for inflation, Morningstar data show.
In previous periods, yields were higher, about 6 percent or 7 percent, said Volpert, who manages about $375 billion. That meant investors received higher coupon payments to offset price declines, he said. Yields in bond funds are so low today that rates don’t have to increase much before investors would see negative returns, he said.
A 10-year Treasury is yielding about 1.75 percent. If yields rise to 2.75 percent, investors would lose about 7.5 percent total return not adjusted for inflation, Volpert said.
“We’ve been in a period of continuously declining interest rates and positive price returns,” Volpert said. “Going forward, what has been a tailwind in terms of performance because yields have been declining will become a headwind.”
Smith, the retired attorney, says he’s not ready to go back into equities. Europe’s sovereign-debt crisis could cause more instability, even though stocks have performed well recently, he said. His conservative strategy has resulted in an 11 percent gain since 2010.
“They’ve performed quite well,” Miriam Sjoblom, associate director of fund analysis at Morningstar, said of bond funds. “If people are just looking at historical returns and are expecting to get the same returns, they might be disappointed.”
Once rates do start to rise, investors should be prepared for a prolonged increase, said Todd Petzel, chief investment officer at Offit Capital, which has $6.5 billion in assets under advisement.
“People really need to think hard about their returns going forward,” he said. “Every bond fund in America has a great three-year number and it’s completely unrealistic for any of them to think they’ll get that going forward.”