Will a Bond Bubble Burst Bust Bond Funds?

If there is a bond bubble and it bursts, will bond funds go bust? Here's a "heads up" 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 the financial and other markets is that few investors are aware of them until they pop. Think: stock market bubble of the year 2000 and real estate in 2007/2008. With 2010 winding down talk of a bond bubble surfaced. Bond funds and real estate used to have one thing in common. People generally considered them good safe investments. Few folks feel that way about real estate anymore, so let's take a closer look at bonds and bubbles. Are bond funds really safe investments today?

A bubble in any market simply refers to extreme over-inflated prices. The lousy stock market and low-interest-rate environment of the new millennium made real estate the investment of choice for making big money. Flipping properties at higher and higher prices became a game most anyone could play with almost NO MONEY DOWN. Many homes doubled in price in less than five years. Enter... the financial crisis and the bursting of the real estate bubble.

What you need to understand today is that there is a bond market where these securities trade, and bond prices are determined much like stock prices are in the stock market. In other words, the price or value of 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. Hence, if you own shares in a bond fund you are invested in bonds; which are not really safe investments. The value of your investment can go up, or it can go down.

To get a handle on things, let's take a look at an example of a typical bond. Think of it as a long-term IOU issued and sold to investors by a government entity or corporation to borrow money. The issuer sells a billion dollars worth of $1000 bonds to the public that mature in 2035 and pay 6% interest per year. Every year the bond owner is promised $60 in interest on this $1000 investment until the year 2035, and this $60 never changes. In 2035 the bond holder (which could be a mutual fund) gets the $1000 in principal back, and the investment ceases to exist.

Does this mean that you must hold this investment until 2035? No, that's where the bond market comes into play. Once the bond is issued and sold to investors it starts trading in 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. Picture this bond as it trades for well over $1000 as interest rates keep dropping to the point that a one-year CD pays less than 1%. Investors are scrambling to buy it, and are willing to pay higher and higher prices to own this and other bonds with attractive interest rates. That's what has sent bond prices up to historically high prices and why there's talk of a bond bubble.

If this trend continues and goes to extremes you've got a bubble that's ready to burst. If or when investors feel that the interest income from bonds and bond funds no longer justifies the risk of holding these investments they will start selling. If they stampede to get out the bond bubble bursts. Bond funds might not go bust, but they would lose significant value. Worst hit would be long-term funds holding bonds that mature in 15 years or more. So, heads 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 where you can take cover 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.

A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.

Jim is the author of a complete investor guide, Invest Informed, designed for average investors or would-be investors of all levels of financial background and experience. To learn more about investments and investing and his new financial guide go to http://www.investinformed.com.