Negativity towards bonds, particularly US Treasury bonds, seems to be peaking, lately. It seems that almost daily another journalist or investment expert recommends avoiding bonds as a component of your investment portfolio. For TSP investors, this means avoiding the F Fund, which represents the aggregate United States bond market, and is the only bond fund available in the TSP. What about the G Fund, you ask? While the G Funds return is based on that of U.S. treasury bonds, your investment in the fund is otherwise unlike a bond investment. Bonds bear the risk of loss. The G Fund does not. It’s like cash that pays a high rate of interest, not like a bond that might produce a positive or a negative return over any period shorter than its life.
The F Fund is designed to replicate the performance of the entire U.S. bond market, including corporate, U.S., state, municipal and agency debt instruments. The components of its return include the interest income received from the debtors and the changes in the market value of the bond – what the bond is worth on the secondary market if you were to sell it. The fund does not pay out the interest and both components are accumulated in the shares’ price each day. While the interest is always a positive amount, the change in market value can be either positive or negative. This means that the share price can go down if the loss in market value exceeds the interest income for the period being measured.
When most bonds are issued, the interest payment amount is fixed – not as a percentage, but as a dollar value. The yield produced by the bond is an after-the-fact calculation that converts the interest payments into a percentage of the price paid for the bond. Consider, for example a $1,000 bond issued with a $100 annual interest payment. The yield for this bond, if you pay $1,000 for it, will be 10 percent per year until the bond matures. But what happens if a year after you purchased the bond, market interest rates for similar bonds have risen to 12 percent and you want to sell your bond? Nobody wants to buy your bond for $1,000 with a 10 percent yield if they can buy another one just like it with a 12 percent yield. You’ll have to discount the price of your bond to make it attractive to a buyer. In fact, you’ll have to discount the price of your bond to $833.33 to make it competitive. At that price, the $100 interest payment will be 12 percent of the buyer’s investment in the bond. If you sold the bond after exactly 1 year, your investment will have lost money; $66.67 to be exact. The bond’s value declined by more than 16 percent, but the $100 interest income offset part of the loss.
These are the kinds of factors that go into calculating the F Fund’s daily share price. The
relationship of market interest rates to changes in a bond’s value, and to the share price of the F Fund, is connected to the recent warnings against holding bonds. Risking market interest rates are bad for bond values, and with today’s low interest rates, is there any way for interest rates to go in the future but up? This is sound logic and I agree that the most likely return for bonds going forward is negative. There is a reason to continue to hold the F Fund in your portfolio, however, even though it will probably lose money over the next few years. The reason is that you are also holding stocks – in the form of the C, S and or I Funds – or even elsewhere in your portfolio. Bond and stock values tend to be negatively correlated. That means that they often move in opposite directions at the same time. Your portfolio should always hold stocks and bonds together, so that each is always hedged by the other. This will help to smooth out the bumps, make your returns more predictable and, if done properly, significantly improve the odds of succeeding in achieving reasonable financial goals – like enjoying reliable retirement income.
The potential for losses in bonds pales in comparison to that for an unhedged stock portfolio. If the stock market continues to rise and interest rates rise along with it, the gains from your stock holdings should dominate, and more than offset the losses in your bond holdings. If the stock market crashes, however, which it has done the last two times it has reached new all-time highs, those bonds will likely jump in value, continue to pay interest, and reduce the magnitude of your loss. And, when it comes to investing for retirement income, avoiding the worst losses is more important that earning a little more during the good years.
Written by Mike Miles
For the Federal Times
Publication February 10, 2014