Bonds and bond funds are a popular investment choice for many Americans. They are widely available, with little risk, and have yielded high returns historically. However, there are good reasons why most financial advisers do not recommend investing in bonds as heavily as most investors do. Despite their drawbacks, however, they are still among the safest ways to invest money, which is why most long-term investors hold some portion of their portfolio in them.
Mutual funds offer an excellent way to diversify even small investments over large stocks at once. Bond mutual funds can be advantageous for those who cannot afford or don’t wish to purchase individual bonds. However, mutual funds that contain only bonds operate under different rules than stock mutual funds, and there are several drawbacks you should be aware of before investing in them.
First and foremost, bond mutual funds almost always have higher fees than stock mutual funds. The expense ratios for most bond mutual funds range from 0.5% to 1%, while the average stock mutual fund has an expense ratio of just 0 . 17%. These fees can quickly eat away at your profits, so it’s essential to compare the costs of various funds before investing.
In addition, when interest rates rise, bond prices fall. It’s known as “interest rate risk.” Because a bond’s value is directly related to the interest rate at which it can be re-sold, a bond issued when interest rates were at their nadir cannot be sold until these rates rise again to make the bond profitable for its owner.
Fluctuations in inflation
The other risk that arises from interest rate fluctuations is inflation, which occurs when the prices of goods and services increase throughout an economy. When this happens, it decreases the value of money since each dollar becomes relatively less valuable than before. Because bond prices are tied to interest rates, they will fall in value as inflation rises. It means investors should expect lower yields on their bonds due to inflation even if nominal interest rates stay low or decline further.
Interest Rate Risk
As stated above, a bond’s value is related to how much can be resold—an inverse relationship exists between the value of a bond and interest rates. Inversely, if interest rates go up, the price of a bond goes down. It’s not only common sense but also backed by academic research. Several theories determine how much a bonds price will drop in response to a change in interest rates, under what conditions they may fall more or less than some predicted amount, and even when bonds might rise due to a rise in the general level of interest rates.
Second, the high fees associated with most mutual funds sold on the market today make them poor investments for short-term investors. The average expense ratio across all mutual fund assets is 0 .25%, while any given bond mutual fund’s fee can be up to 1%. However, these fees are charged regardless of whether or not investors make money on their investments. Because short-term investors can quickly get out of a mutual fund before these fees start to eat into returns, they should only invest in bond funds if they’re willing to hold for several years, if not longer.
Suppose your investment goals don’t fall within the time frame during which you expect interest rates to rise; investing in bonds is a safe choice that will help you grow your wealth over time without taking much risk at all. However, suppose you need your money soon or intend to withdraw it as quickly as attractive returns appear elsewhere. In that case, you should be wary of the risks outlined above and consider other types of investments.
There are several drawbacks to investing in bond mutual funds. Although they can be advantageous for long-term investors, short-term investors and those who don’t want to take the time to select and monitor individual bonds individually should stay away.