Bond Funds Hoarding Cash

Bond Funds Hoarding Cash

Bond funds were loading up with cash anticipating volatility and rate increases according to a recent article in the Wall Street Journal. This should spark some serious thinking about investing in bond funds.

Bond funds are very popular because they are easy to buy or sell and create the illusion that their investors are ensconced in a safe fixed income investment. This headline has to prove the opposite. They are not safe and in many cases do not provide a fixed reasonable cash flow.

The value of bond funds fluctuate widely based on continuously changing interest rates. When rates decrease, the value of the funds increase, and when rates increase, the value of the funds decrease. We have seen an extended period when rates have dropped causing many bond funds to increase in value. Many of the fund promoters advertised their high “total return” on their funds during this period. The total return is a combination of the current interest payments plus the increase (or decrease) in the value of the fund. If the total returns were high then what will happen when rates increase? The value of the funds will eventually drop. And that is what is on the horizon for every bond fund, thus the flight to cash by some of the managers.

Another reason for the cash is to have funds available to meet redemptions of investors abandoning their bond funds. When investors leave a mutual fund quicker than new investors come in, the fund needs to sell some of its portfolio to raise the cash to pay the redeeming owners. This causes an influx of bonds on the market further causing a drop in the prices [more supply than demand means lower prices – Economics 101] exacerbating the situation. To try to offset this, some funds are using greater leverage, loading up on lower rated bonds or trading in derivatives. In a volatile market all of these strategies can backfire potentially magnifying losses. Bond fund liquidity now has become a great concern by the SEC and very large financial institutions such as Citigroup. Further, many funds invested in low yielding treasuries chasing the increases in value to boost up their total return, so the annual interest check wasn’t even that great. Some changes in bond fund managers also played a role in the recent volatility. This is getting very confusing, especially when the typical investor (based on my client base) invests in bond funds for a “safe” fixed return.

My suggestion is for you to consider not investing in bond funds but to buy individual bonds. I’ve explained this in a few previous blogs and while I continuously reconsider my thoughts and recommendations, this has not changed since I’ve been posting these blogs.

You don’t have to believe me, just look at what the bond fund managers are doing.