How risky are bond mutual funds?

May 10, 2009 3:03 AM

How risky are bond mutual funds?

Help me understand the risk of bond mutual funds. Is a fund like VBMFX a good place to put some money for 1-2 years? How likely is this sort of fund to lose money during those two years? What general economic conditions affect the performance of bond funds?

posted by david1230 to work & money (3 comments total)

As VMBFX consists primarily of US Treasury Bills, it should be as good as "the full faith and credit of the US government". Not coincidentally, this is the same standard of value that your funds would have if turned into currency and stored in your mattress (although the mutual fund is probably less at risk of robbery).

Relative to any US based investment, you can't be much less risky as over the the life of the fund its worst loss (Jun 2003 - Oct 2008) was only 10% but that's looking at wild extremes, overall the fund is much more stable. Over a comparable period, the S&P 500 lost 24-30% of its value. Conversely, Treasury bills have little prospect of gaining much value either. Only a total collapse of the US - hence world - economy is likely to adversely affect the value of VMBFX, in which case you'd probably be better off if your funds were stored as wheat or corn or sumptin.

Vanguard could also fail in principle, but insofar as rule of law is maintained, the bonds purchased on your behalf should be recoverable.

Disclaimer: I am not an economic advisor; I don't even handle my own investments.
posted by fydfyd at 5:28 AM on May 10

The main things that can affect the performance of a bond fund are changes in market interest rates and changes in the creditworthiness of the bond issuers. When choosing a bond fund, that means you want to look at the average duration, shown at the bottom right of Vanguard's page on VMBFX (in this case 3.7 years) and the issuer/quality of the underlying bonds (under the Portfolio and Management tab of the Vanguard page).

The duration is a number that gauges how much the fund can lose in percent when interest rates rise 1%. So the smaller the number, the smaller that risk. VMBFX's 3.7 is not very high but there are Vanguard funds with lower durations, like VFISX at 2.2, or any others with the name "Short term." There is a good chance that interest rates will go up in the next 1-2 years since they're extremely low right now. If the economy starts to recover or people start fearing near-term inflation, rates will likely rise.

The issuer/quality is also important because in bad economic times, the credit rating of companies will get downgraded and some will default. In that case, people will prefer government-backed bonds, since there is pretty much no chance the U.S. government will default. VMBFX is NOT primarily Treasury bills. It has longer maturities, some commercial investment grade bonds, and a large chunk of government mortgage-backed securities. The MBS are government-backed so most people think that they are as safe as treasuries, but there is a very tiny chance the government could somehow choose to default on those but not regular treasuries. The main risk in VMBFX is the commercial stuff but that's only about 25% of the bonds. If economic conditions get a lot worse in the coming 1-2 years, more companies will default and that 25% might drop to say 20%.

VBMFX is not very risky but it kind of depends on how badly you'll need the full amount of money in 1-2 years. VFISX is almost all treasuries and shorter duration so that's safer. Even safer still would be bank CDs (backed by the FDIC) or one of Vanguard's money market funds like VMMXX which you can think of like a bond fund of very short duration.
posted by Durin's Bane at 6:49 AM on May 10 [2 favorites]

Durin's Bane nailed it. If you need the money in the next couple of years you shouldn't do anything riskier than the shortest-term, highest-quality bond fund, a high-yield savings account, or a money market fund.

Rates are low now, but who knows how long that will last - as rates go up the longer-term bond funds will lose more money than the short-term ones (aka duration). You might do better by finding a decent rate on a 2-year CD. Looks like you can get something in the 2.5-3% range currently.
posted by Fin Azvandi at 12:49 PM on May 10