Why You'd Better Find Out What's In Your Bond Fund

Economic and investing turbulence in Greece, China and Puerto Rico as well as the likelihood of interest rates rising in the U.S. soon are strong reasons to take a hard look at what’s in your bond fund portfolios. Never mind today's New York Stock Exchange 3 1/2-hour trading halt. Your bond holdings may be riskier than you think.

Most investors consider bonds a source of stability in their portfolios, and with good reason. The broad bond market, as measured by the Barclays Aggregate Index, has had only three down years over the past 35 years, with its worst calendar year since 1980 in 1994, when the index dipped 2.9 percent. Compared to stocks, which lost 37 percent in 2008 (as measured by the S&P 500), bonds look relatively sedate.

But some bonds — and bond funds — are riskier than others. In general, the higher the perceived risk of a bond, the higher the interest rate the issuer must pay to attract investors.

Understanding bond risk can help you avoid the kind of surprises that investors received in 2008, when many fixed-income securities dropped far more than the overall bond market. At that time, when the bond market was up 5.2 percent for the year, some innocuous-sounding bond funds lost 20 percent or more and one huge high-yield bond fund plummeted 78 percent.

Here’s a guide to the various types of bond risk and how to scrutinize (and perhaps sell) your bond funds accordingly:

When interest rates rise, the value of lower-paying, existing bonds drops. Interest rate risk generally rises with maturity (a bond’s maturity date is when principal is due and repaid to an investor and interest payments stop): the further away the bond’s maturity, the more sensitive it is to interest-rate fluctuations.

This is why the ultra-short securities in money-market funds make them virtually insensitive to interest rate fluctuations, while 30-year bonds can lose or gain significant value when interest rates move.

The best way to judge the interest rate risk of a bond fund is to look at its effective duration. Duration reveals how much valuation shift is expected with a change in interest rates. A bond fund with a duration of five, for instance, can be expected to lose 5 percent of its value if rates rise by 1 percentage point or gain 5 percent if rates drop 1 percentage point. If rates were to rise 2 percentage points, holders could expect a 10 percent loss in value.

With interest rates at historic lows and the Federal Reserve hinting at moving the prime rate upward by the end of the year, the likelihood of higher U.S. bond rates seems high. You can check out the duration of your bond fund by reviewing its fact sheets and reports or by entering its name or ticker at the Morningstar website.

Investors should also be aware of the chance of an issuer defaulting on its bonds — which seems possible in Greece as of this writing. The recent crisis in Puerto Rican debt is a prime example of default risk, too. By contrast, the default risk is considered zero for U.S. Treasury bonds.

The possibility of default increases as the quality of the issuer decreases. This is an accepted reality with high-yield (or junk) bonds. While investors receive higher yields from them than with other bonds, they take on greater default risk. This was evident during the 2008 financial crisis when companies with flimsy fundamentals were in particular jeopardy. The value of high-yield bond funds plunged that year, with many aggressive ones losing half or more of their value.

You can find the distribution of quality in your bond fund — from the highest rating of AAA to D, which is a bond in default — from the fund itself or at Morningstar.com. Bonds rated BB and lower are considered junk bonds.

You can’t always tell the quality of holdings by a fund’s name; 53 percent of U.S. municipal bond funds have exposure to Puerto Rico, for example, according to Morningstar. Puerto Rican bonds are triple tax free, exempt from federal, state and local income taxes.

A risk-managed, diversified fund will typically have a small percentage of these notes, an exposure that may have decreased since Puerto Rican debt has been downgraded. (Puerto Rican officials are expected to renegotiate terms for their $72 billion debt when they meet with creditors Monday; the island is not allowed to file for municipal bankruptcy.)

Take the time to look under your fund’s hood for bond quality.

Liquidity risk is the danger that there will be more sellers than buyers for a particular bond, causing its valuation to crater. This risk is minimal with heavily traded securities such as U.S. Treasuries and rises for thinly traded bonds.

The most dangerous scenario, from a liquidity risk perspective, is when many bond investors try to liquidate at the same time. Mutual funds have been unloading Chinese government and corporate bonds lately, which has sent their prices down and yields up.

Unfortunately, there is no easy metric for measuring liquidity risk. But since high-yield bonds tend to come from smaller, less-secure issuers, there is a general correlation between liquidity risk and yield. So, all things being equal, the higher the yield of bonds in a fund, the higher the liquidity risk of the holdings.

As fund managers seek to outperform their peers and benchmarks to attract investors, some take on extra risk by employing leverage and buying derivatives.

Leverage — the technical word for borrowing — lets managers buy more bonds than their assets alone would purchase. Derivatives are bond-based securities that can act in ways similar to leverage.

Since derivatives are also used to manage risk, however, it can be difficult to assess their potential impact. That said, leverage and excessive derivative use offer the potential for additional risk and volatility.

You can ask your bond fund about its use of leverage and derivatives and look at its annual report to see if the funds’ total investments exceed net assets (which means leverage). Or you can opt for funds that specifically state they avoid these tools.

In today’s low-interest-rate world (the U.S. government’s new inflation-adjusted I-bonds yield 0 percent), the promise of a higher return can be alluring.

But no investment adviser or fund manager can increase yield without increasing risk. If your bond fund yields considerably more than its peers, this can merit special attention. Getting a small boost in income now may not be worth the possibility of significant future losses later.