Its a conundrum. This is what Federal Reserve Chairman Alan Greenspan recently said of the current state of long-term interest rates. The situation that exists with short- term rates getting measured increases, while long-term rates havent moved much is a topic that has been confusing many people, not just Chairman Greenspan. This conundrum is what we spoke of in our first column because it was perplexing us too. Within a day of Greenspans testimony, long-term bond prices started dropping substantially, just as we had predicted in the column.
But, theres another conundrum happening out there that we see a lot of which is concerning us: The issue of principal guarantees within bond investments. A new client of ours, Bob, relies heavily on fixed-income as an important part of his retirement plan. Recently, while rebalancing his investment portfolio, he expressed to us that he was confused about the status of the bond funds he has had for years. Bob said that he heard his principal isnt guaranteed and wanted to know if that is true, even though they are government bond funds. We were put in a tough position where we had to explain a very important fact to Bob that commonly gets overlooked. The fact is that government bond mutual funds have no principal guarantees, as well as inconsistent and non-predictable income distributions!
Although government bonds and government bond trusts are principal guaranteed, investing in bond funds is not done on the same terms. In fact, while an individual bond pays the owner of the bond a consistent amount on each coupon date, a bond fund is not consistent by any stretch of the imagination. The distribution received from the fund depends entirely on how well the bonds fare within the bond fund. At any given distribution date, the amount of money received can vary greatly. Therefore, its not even appropriate to label a bond mutual fund as a fixed-income product! This matter means a lot to Bob, especially because him and his wife depend on a certain amount of fixed-income coming in consistently in predictable amounts. If that income doesnt come in as anticipated, his lifestyle could be dramatically affected.
Bond investors are often under the impression that government bond mutual funds are principal guaranteed. When this is the case, its usually because either the investment hasnt been explained correctly or the investor has not understood correctly, or possibly even both. Weve seen this misunderstanding of bond fund investments perpetuate itself for many years. As late as last week, we were running a seminar in Mineola, NY on the effects of rising rates on bond portfolios. Most of the people who were in attendance, and currently invested in government bond funds, were not clear on this important point.
The reasoning behind why there is no principal guarantee is that mutual funds are open-ended. Said differently, shares are offered on a continuous basis and have no maturity date. If theres no maturity, theres no date for principal repayment. Hence, no principal guarantee! Conversely, government treasury bonds, bills and notes, and government bond trusts do have a finite life. In other words, they have a fixed maturity date. Therefore, when the bonds mature, principal is repaid. Hence, there is a guarantee of principal!
Lets take a specific example. When Bob spends $10,000 to buy 10-year government treasury bonds at 5% yield, he will receive $500 dollars of fixed income annually, and is guaranteed every dime of his initial principal at maturity, which is 10 years from the date of issue. These bond investments are backed by the full faith and taxing power of the United States federal government. In the case of Bob buying into a mutual bond fund, even though the bonds in the fund are government treasury bonds, the fund itself has no maturity date, which boils down to not having a principal guarantee. By the way folks, there is no exception to this!
Even with corporate, municipal, and junk bonds, the same system applies in regard to principal. The issuing institution backs those bonds and the rating is determined by the institutions ability to pay. If youre looking for a perfect example of how some bad news can greatly affect the credit worthiness of even a premier blue chip companys corporate bonds, take a look at or ask your advisor about the current market situation with General Motors GMAC bonds. Like government bond funds, corporate and municipal bond funds have no principal guarantees either.
Heres the bottom line: Were not trying to turn people off completely from bond mutual funds! There are some appropriate uses, and we stress the word some, for bond mutual fund investments, but the key is to understand what youre doing. The potential risk and reward need to be weighed, so no matter what the outcome of the investment, hopefully feeling regret wont be felt for not properly being informed. Just like Bob needs his predictable and continuous stream of income from his bonds through his retirement years, we know that there are many more retirees that are dependent on their bond portfolio income as well. We want to stress that it is to your advantage to not just fly solo on this one, but to get advice from a financial professional.
Again, probably the most important thing is dont be afraid to ask questions. We dont think that any question is stupid or trivial. If theres something that isnt clear, then its worth asking about! People always want to talk about risk and guarantees, which is extremely important to be aware of so feelings of regret dont set in at a later date if an investment underperformed and you unknowingly lost money that you had thought was supposed to be safe.
Don is President of Conrad Capital Management, an independent registered investment advisor in Melville, New York. Before launching his own firm in 1997, Don held a combined seventeen-year tenure at E.F. Hutton and PaineWebber, where he served as Senior Vice-President at both firms.
Don can be reached by phone: (631) 439-7878 or email: don@conradcapital.com Also, to learn more about Conrad Capital Management, visit the website at: http://www.conradcapital.com
Don started his career in the late 1970s at a nationally recognized mutual fund company and was recruited after three years by E.F. Hutton Company to work in the consumer retail division. During his thirteen-year tenure there, he spent two years specializing in and trading the 30-year treasury bond. For the last five years, he served as a senior vice president focusing his efforts in the Consulting Services division, maintaining offices in both Long Island and Manhattan.
In 1993, he was recruited by PaineWebber as a Senior Vice President in the consumer retail division. In addition to managing his clients assets, he was asked by senior management to conduct a nationwide tour to train financial consultants in the Consulting Services division. Don also made a video on the use of advanced technology in the financial services industry. This video was distributed to PaineWebber offices internationally.
After almost five years at PaineWebber, Don decided to pursue his dream by starting Conrad Capital Management in order to offer his clients more choices and flexibility.