Long-Term Bond Funds

I was just working on a review of a new client’s 401K and I noticed a holding called “XYZ Long-Term Bond Fund”. Fine. Nothing terribly special about that. However it occurred to me just how misleading such a fund name can be to the uninitiated.

Many people not versed in financial matters might see this choice and think “I’m investing for the long-term, this is for me.” In their mind, retirement is far off, perhaps twenty years or so, and investing in 20 or 30 year bonds might seem like a perfect fit. Unfortunately, things aren’t so simple and the funds named like this can be very misleading.

Let’s start with what a “long-term” bond is. Although definitions vary, a “long-term” bond is typically considered one that matures in more than 10 years. Many long-term bonds are 20 years plus. Remember, bond prices move inversely with interest rates. For example if interest rates rise most bonds will fall in price (at least temporarily- they should mature at par barring default). The longer a bond’s maturity, the more sensitive it is to changes in interest rates. That means a bond with say 25 years to maturity will be quite sensitive to changes in interest rates. Such a bond may go up or down in price by 10, 20, even 30% depending on changes in rates (in addition to the interest itself).

Buying such a bond and holding to maturity is not much of a problem if you don’t plan to sell before it matures. As long as you can tolerate the ups and downs, the bond’s maturity will increasingly shrink as time goes on. However, if you buy a bond fund with 20-25 years to maturity, the fund will maintain that long dated maturity by selling bonds as they age and buying newer bonds with longer maturities. Most funds try to keep the average maturity in a range.

The downside to this approach is that you can lose money permanently. Say interest rates go up and the fund’s holdings decline in value. To maintain the average maturity, the fund sells some of those at a loss and buys newer, longer term bonds. By selling at a loss, the fund locks in the decline in value which cannot be recouped as the bond inches closer to maturity.

What all this means is that a “long-term bond fund” does not connote it is appropriate for long-term investors. It means that one particular characteristic of bonds – the maturity- is described in the name. Unless you understand bonds, knowing the effect that this maturity can have on your investment performance won’t be clear and the risk assumed probably isn’t well understood either.