Best Days Over for Bonds? What’s Next?

Last week bond guru Bill Gross voiced concerns about investors who’ve fled to bonds in the past year. He thinks they’ve “seen their best days” according to a Bloomberg report.

His fund, the PIMCO Total Return fund, is now the largest mutual fund in history. You have to hand it to him for being honest when it may mean less money in his product. Let’s hope his worries affect how he manages the fund.

Why All the Bonds?

Why have investors piled into bond funds like his? They didn’t like what was happening in stock funds. With miserable rates on money market funds and bank accounts, some also reach for a little more return by using bonds. Those are safe, right?

They tend to have less risk than stocks. Safer issuers like the US Government and other well-funded entities are reasonably likely to pay off bonds.

What’s the Concern?

Bond prices (not the interest payments or values at maturity) can move up and down over time as they’re traded on markets.

Bond and bond fund prices can suffer when interest rates rise. Think of where rates are now and if they’re likely to go up or down. We can’t know if or when rates will rise or how any investment will be affected, but odds are good that longer term bond funds will face hard times.

Some use “duration” as a way to gauge risk; a one percent rise in interest rates may result in a percentage loss equal to a fund’s duration. If the duration is 3, a 1% rate increase means you should brace for a 3% loss. Sometimes it doesn’t work out that way but it’s a rule of thumb.

There are lots of pictures and formulas here if you want to dig into this.

So What?

Over the long term, it may not matter. But PIMCO Total Return didn’t get to be the largest fund in history by people thinking about the long term.

This may be nonsense, but see what you think:

  1. Stocks lost money in the dot-com bust
  2. People flocked to real estate because it was doing better
  3. Real estate lost money in the subprime crisis
  4. Briefly, people flocked to banks and short term treasuries for safety
  5. People move to bonds because they’re “doing better”
  6. Interest rates will rise someday

Is there a pattern here?

It’s not that you shouldn’t own bonds. Just consider why you own them.