Bond mutual funds are typically viewed as plain vanilla, conservative investments. Sure they can lose money. However, there is not a concern that they will crash and burn…..or is there?
The Financial Stability Oversight Council issued a stern warning in their annual report this week. They stated that “exchange-traded funds and fixed income mutual funds (bond mutual funds) could potentially pose risks to the marketplace during times of stress.”
I can think of many types of mutual funds that could warrant a warning and bond funds wouldn’t hit that list. However, there is a real risk and it is one that most bond mutual fund holders don’t understand. It all comes down to liquidity.
Here is the risk – Let’s say there is a financial crisis, bonds are losing money, and you want out. You call the mutual fund company or your financial advisor and give instructions to sell your bond fund. Each day the manager of your bond mutual fund receives orders to buy the fund and to sell the fund. Hopefully, there is plenty of cash available to execute your order to sell your shares of the bond fund.
If there is not enough money available, then the mutual fund manager has to sell bonds to create cash. Ideally there is someone who wants to buy those bonds. What if there isn’t? What if there isn’t a buyer for the bond at market price and there are more sellers than buyers?
There are always buyers. However, there might be a buyer for the bond at a much lower price. The fund manager needs cash and has no choice but to sell it at a lower price.
If this happens on a massive scale where many are investors are selling their bond mutual funds, then a potential problem develops where the fund manager is selling the bonds at much lower levels just to get cash. Now, add in a financial crisis where the bond market is going down and you have a toxic situation on your hands.
Your account was worth $50,000 and after the sale happens you walk away with much lower.
This the big difference between holding a bond and holding a bond mutual fund. When you are issued a bond, you are paid interest during the term of that bond. At the end of the term, you are paid back that money in most cases. So, it doesn’t matter if the price fluctuates. You just hope that the company you bought the bond from stays solvent. You don’t get that luxury with bond mutual fund. The fund manager is forced to sell something that he or she would prefer to hold but has to do so at of necessity.
So, if you are holding bond funds, you might want to do a little further investigation. You might be holding onto a lot more risk than you think.
Bob Brooks hosts the Prudent Money Radio Show heard weekdays Monday through Friday on 91.3, 97.5, and 99.9 in the Dallas Fort Worth Area. You can reach Bob at firstname.lastname@example.org.