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Will a bond bubble burst bond funds?

If there is a bond bubble and it bursts, will the bond funds go bust? Here’s a “warning” for the millions of investors in bond funds. These fixed income investments may not be the safe investments you think they are.

The funny thing about bubbles in financial and other markets is that few investors are aware of them until they burst. Think: stock market bubble of the year 2000 and real estate in 2007/2008. With the end of 2010, there was talk of a bond bubble. Bond funds and real estate used to have one thing in common. People generally consider them to be good safe investments. Few people feel this way about real estate, so let’s take a closer look at the bumps and bubbles. Are Bond Funds Really Safe Investments Today?

A bubble in any market simply refers to extremely inflated prices. The dismal stock market and low interest rate environment of the new millennium made real estate the investment of choice for making big bucks. Trading properties at higher and higher prices became a game that almost anyone could play with almost NO UP CASH. Many houses doubled in price in less than five years. Enter… the financial crisis and the bursting of the housing bubble.

What you need to understand today is that there is a bond market where these securities are traded, and bond prices are determined much like stock prices on the stock market. In other words, the price or value of the bonds will fluctuate as investors buy and sell them in the market. Bond funds simply hold and manage a portfolio of these fixed income investments for their investors. So if you own shares in a bond fund, you’re invested in bonds; They are not really safe investments. The value of your investment may go down as well as up.

To get things straight, let’s take a look at an example of a typical link. Think of it as a long-term note issued and sold to investors by a government entity or corporation to borrow money. The issuer sells $1 billion worth of $1,000 bonds to the public that mature in 2035 and pay 6% annual interest. Each year the bond owner is promised $60 in interest on this $1,000 investment through the year 2035, and this $60 never changes. In 2035, the bondholder (which could be a mutual fund) gets back the $1,000 in principal, and the investment ceases to exist.

Does this mean that you should keep this investment until 2035? No, that’s where the bond market comes into play. Once the bond is issued and sold to investors, it begins trading on the bond market, where any interested investor can buy or sell it. The 6% interest rate will never change, but the price will fluctuate as it trades over time. Imagine this bond as it trades for over $1000 as interest rates continue to fall to the point where a one year CD pays less than 1%. Investors are rushing to buy it and are willing to pay ever higher prices to own this and other bonds with attractive interest rates. That is what has pushed up bond prices to historically high levels and that is why there is talk of a bond bubble.

If this trend continues and goes to extremes, you have a bubble that is about to burst. If investors feel that the interest income from bonds and bond funds is no longer worth the risk of holding these investments, they will start selling. If they stampede out, the bond bubble bursts. Bond funds might not go bust, but they would lose significant value. Hardest hit would be long-term funds that have bonds maturing in 15 years or more. So head up. Don’t ignore your bond investments and pay attention to the bond market.

If a bond bubble appears on the horizon, there are safe investments you can take refuge in without leaving your mutual fund company. Money market funds pay interest in the form of dividends and do not fluctuate in value like bond funds do.

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