Fixed Income Funds – Are Bond Funds Safe Fixed Income Investments?
Many people assume that since fixed income investments are relatively conservative that there is no risk in owning them. While bond funds can achieve some degree of diversification by holding many different bonds at one time, there are a few risks that you should consider before investing in them.
Interest Rate Risk – Economics 101 states that if interest rates increase, then bond prices usually decrease. If interest rates decrease, then bond prices will usually increase. If you are planning on holding the bonds to maturity, then you have nothing to worry about. Unfortunately, when you are invested in a bond fund, some young hotshot manager will make the decision of when to sell for you. If you sell during a time of rising interest rates, you may experience a loss on your bond. So much for the safety of owning bonds!
Inflation Risk – As our government continues to print more and more money, the risk of inflation increases. The real effect of inflation is not some theoretical guestimate. Inflation erodes the value of your money. If you are depending on this money to put food on the table, inflation can prevent this from occuring. Investing in Treasury Inflation-Protected bonds (known as TIPs) can help offset some of this risk, since the principle invested is adjusted for increases in inflation.
Credit Risk – As with any fixed income investment, bonds carry the risk of default. What this basically means is that the issuer is no longer able to make the principle or interest payments. Many people have learned this lesson the hard way with Fannie Mae and Freddie Mac. Once considered to be of high quality, now most would consider them extremely dangerous. Fixed Income Funds, such as bond funds, reduce this risk by diversifying across many different types of bonds. While your risk is somewhat reduced, you are still subject to losses due to poor managament decisions made by the fund manager. Always read the fund’s prospectus before investing. This will help ensure that you understand the fund’s credit standards.
Do you own any fixed income funds? How are they performing for you? I would love to hear from you.
