In part one of this series, I explained that, although mutual funds make good investments, they actually introduce new risks to a saver because they expose shareholders to market forces. I brought up the problem that happens in the bond market when interest rates seem too low for a bond. In this article, I expand on interest rate risk. I explain that a bond holder can choose to ignore it, but a mutual fund shareholder has no choice but to be exposed to it.
Interest Rate Risk: A Risk for Investors
There are two reasons why a bond’s interest rate might seem low in the future to investors in the bond market. One reason would be that the Federal Reserve has decided to raise interest rates significantly during the bond’s life. A five percent bond might have seemed like a great investment 10 years ago, but if your checking account is now paying five percent, it’s a sign that times have really changed. All bonds, including inflation protected bonds, are subject to this kind of “interest rate risk.” It’s not really a risk, though. It’s missing out on a better opportunity. Your money is still all there and it will all be returned to you at the bond’s maturity. You will have received all the promised interest at that time. The only difference is that you could have possibly invested in a different way and done better during that same period of time. Notice that this is an investment problem, not a savings issue. If you were trying to protect your savings, then a bond would still have been effective at insuring your money. That’s why I believe that interest rate risk is a risk to opportunity investors, not to savers.
Inflation Risk: A Problem for Everyone
The second reason why a bond’s interest rate might seem low to investors in the future, is if our money experiences a loss in purchasing power. If minimum wage goes up to $50 an hour, a $1000 bond isn’t going to seem as valuable to us when it matures as it did when minimum wage was $10 per hour. That’s why we protect our savings from inflation. Typical bonds cannot protect us against this. In fact, they are highly exposed to it. That’s why we want to use inflation protected bonds for our long term savings instead of typical bonds. With all of this as background, let’s consider a very strange marketplace. Let’s consider the inflation protected bond market.
The Inflation Protected Bond Market
As I mentioned before, because mutual fund managers trade bonds before they mature, bond mutual funds are exposed to the bond market. This same thing is true for mutual funds that hold inflation protected bonds inside of them, so let’s consider what causes the market price of an inflation-protected bond to change.
It turns out that one of the worst things you can do to an inflation protected bond is to expose it to the market. Trying to predict the future value of an inflation protected bond is complicated and the market prices change in complex ways. Inflation protected bonds are affected by the possibility of a rise in interest rates, just like other bonds, but they tend to be a place of safety for people seeking to protect themselves from the possibility of inflation. If it is perceived that inflation is going up more than interest rates, then prices may go up in this market. If interest rates go up while inflation drops, it could mean that prices drop considerably.
Another thing that can cause prices to drop is when there are a lot of people leaving the bond market which causes the value of existing bonds to drop. It is not unusual for bonds to be priced lower than it cost to buy them, even when they have a large inflation adjustment.
A True Story
At the time that I write this, inflation protected bond funds have not fully recovered from a drop that the market experienced in 2013. What this means is that if you were to have purchased shares in an inflation protected bond fund in 2013, you would have failed to keep up with inflation. This is a clear demonstration of the risk that you take when you put your savings into an inflation protected bond fund. This is proof that it may not keep up with inflation for certain time periods. The market probably will recover at some point in time. The only problem is that we don’t know when that is. That’s what I call timing risk and that’s not a part of my savings protection strategy.
Protection from the Market
By simply choosing to buy your own bonds and hold them until maturity, you escape the wild prices changes in the bond market. With a “buy and hold” strategy, you can avoid the fear that comes from watching market prices suddenly drop. When you hold your bonds until they mature, you will always receive the amount you expect to receive, adjusted for inflation.
Focusing on the Right Thing
If you have a 401k or an investment account at a brokerage, you probably have noticed that their tracking software focuses on market prices. When you are a buy and hold savings investor, this can be very distracting and misleading. In order to focus on the right things, you must train yourself to not pay attention to market prices since they don’t mean anything to you. We shouldn’t be too excited when market prices are up and we should not be worried when they are down.
That’s one of the reasons that I decided to make software that tracks the real value of our long-term savings. By focusing on the maturity value and not the current price, it puts our minds at ease, knowing that we are still on the right track.