Inflation protected bonds are a great way to protect your long-term savings and it’s easy assume that inflation protected mutual funds or ETFs are just as good, but that’s actually not the case. There’s increased risk to savers who hold bonds in a mutual fund. In this two part series, I explain some of the risks and why I don’t recommend using funds for this purpose.
The Benefits of Mutual Funds
Mutual funds are pretty convenient to an investor. They are relatively easy to buy and sell and are managed by professionals. They allow us to leave our investments in highly qualified hands.
Mutual funds are also very well advertised. You can find out a lot about them because they are in almost everyone’s 401k. Mutual funds can be a win-win situation for the novice investor and the experienced money manager. The problem with mutual funds and ETF’s is that they are inherently more risky than bonds because they have added exposure to market forces.
Preservation vs. Opportunity Investments
When we are saving, we intend to preserve our money for a specific point in time. Mutual funds help us take advantage of investment opportunities, but they don’t commit to pay at a point in time. We are able to pick a good management team and pay them to pick the best time to buy and sell stocks and bonds, but they don’t promise that our money will be there when we need it.
As I mentioned in the article: “Stressed about Savings? Divide and Conquer!” it’s very helpful to divide your money into two separate parts before you start. Mutual funds can be a valuable part of the opportunity side of your investing, but too risky for the preservation side.
The Safety of Bonds
Bonds have traditionally been a much better place to store money for long term savings. That’s because bonds are loans with a due date. When a bond matures, you get all your money back. I discuss this at length in the article: “Why Bonds are Smart for Savings”
The danger bonds have is the possibility that your money won’t be paid back to you at all. We do have to consider who we are loaning our money to. Risky bonds are not good investments for savings either. You can diversify them, but they are still not good preservation tools because you may not get all your money back when you need it. Good quality bonds, however, can be seen as a good method of saving for the long term as long as they are adjusted for inflation. That’s because you have a reasonable commitment that you will be paid on time. Mutual funds, on the other hand, don’t come with a commitment to pay anything.
As safe as bonds are, you would think that putting bonds into a mutual fund or an ETF would produce the best of both worlds, but that’s not the case. A surprisingly risky set of things happen when you put bonds into a fund.
When you invest in a bond fund, you are not owed anything anymore! When you own a bond directly, the bond issuers legally owe you money on a specific date. In a mutual fund, the bond issuers owe the fund money, but they don’t owe you anything directly. This is very important to understand. If you intend to insure your savings, then it’s better to choose a method of savings that provides you a direct guarantee.
You might be wondering why a bond fund would not be able to pass along the bond issuer’s guarantee. There are some valid reasons.
Funds are Mutual, Bonds are Not
It’s important to understand that a bond fund is owned by a group of people. This creates a problem for savers. In order for a bond to preserve your money, you must hold that bond until it matures. There is no money available until a bond matures, unless you are willing to sell the bond at the current market rate. Funds, on the other hand, allow shareholders the ability to buy and sell at any time. If all of the other shareholders had the same intentions as you, it might work well to use a bond mutual fund, but that isn’t the case at all. There are some shareholders that may actually sell their shares before the bonds in the fund mature. If enough people do that at the same time, it could force the managers to sell some of the bonds at a rate that is lower than what was paid for them. As you patiently hold your shares, the value in the fund would go down because of what others decide to do.
Bond Market Exposure
What this tells us is that by putting a bond into a fund, it exposes the fund to the bond market which can be as unreliable as the stock market. If the bonds are always held to maturity, they have no exposure to the bond market and there is nothing to worry about. I have found that bond funds usually follow bond market prices, not bond maturity values.
Let’s consider some of the risks the bond market exposes an investor to. Remember that the bond market is just a place to buy and sell loans that haven’t been paid back yet. The market is subject to what buyers and sellers perceive about the future. Since these loans are dependent on an interest rate, investors are exposed to the potential that the bond’s interest rate will seem small in the future compared to newer bonds and other investments that become available. Since investors want to hold loans with the largest payout, the loans with the lower interest rates would lose market value. They could even lose enough value that they temporarily fall below the original principal. If a fund manager is forced to sell at that point to pay a mutual fund shareholder, it deeply hurts the fund. Since you own a share of that fund, it hurts you too. When you buy a bond directly, you can hold the bond and ignore the market.