Bond funds can lose value when interest rates rise. Bond prices are inversely related to interest rates, because existing bonds usually offer fixed interest payments that cannot respond to higher prevailing rates. These bonds lose value in a market downturn as bond buyers demand higher interest rates. You can protect yourself from a lower bond market by carefully choosing which bond funds you select. Bond funds are available as mutual funds or exchange-traded funds. Both types provide diversification and relatively low fees.
Short-Term Bond Funds
Short-term bonds mature in three years or less. By concentrating on these during a market downturn, you can avoid most of the loss experienced by long-term bond funds. Bonds pay their face values at maturity. When the maturity date is imminent, the price of a bond converges on its face value, eliminating a capital loss. Short-term bond funds that limit exposure to maturities of six months or less tend to be very stable through all market conditions.
Floating-Rate Bond Funds
“Floaters” are bonds with variable interest rates. Issuers update the periodic interest payments on floaters to align them with prevailing interest rates. Because the interest rates on floaters match current rates, the prices of these bonds remain stable in down markets. Of course, they also remain stable in up markets, so floating-rate bond funds tend to attract investors who are interested solely in income rather than those who favor a mix of income and capital growth.
High-Yield Corporate Bond Funds
Interest rates tend to rise with inflation, which itself often rises from an increase in economic activity. High-yield corporate bonds have low safety ratings in that their issuers are struggling companies. These are precisely the companies that benefit from an upturn in the economic cycle. When a high-yield issuer becomes more financially stable, its debt becomes less prone to default and thus more valuable. As these bonds receive higher ratings, their prices increase and buck the predominant downtrend in the bond market. High-yield bond funds can thus provide a generous income flow combined with capital appreciation, even in a down market.
Inverse Bond Funds
For aggressive bond investors, one way to benefit from a market downturn is to invest in inverse bond funds. Using a variety of techniques and financial instruments, inverse bond funds gain value when interest rates rise. Some funds are tied to bond indexes and others concentrate on a particular type of bond. In any case, these funds will profit as other bond funds register losses. For the extremely aggressive, leveraged inverse funds provide double or triple the return — and risk — of regular inverse bond funds.
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