Are bonds funds riskier than bonds? Yes, and here’s why.

December 4th, 2012 by

A recent article in Seeking Alpha, “Are bond funds riskier than bonds?” by Robert Keyfitz makes the argument that the mainstream financial media has answered this question incorrectly. Suze Orman, Barrons, and Investopedia have all run articles stating that owning individual bonds is less risky than owning bond funds. Mr. Keyfitz argues that that owning a fund is no more risky than than owning individual bonds.

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Who is right? Both are.

Owning a bond fund versus individual bonds in most cases will not provide a major difference in your expected return over longer-holding periods. Mr. Keyfitz’s argument assumes that an investor will always be re-investing their funds and not consume their wealth. (Not live off it during retirement.)

However, if your are going to need to go into your brokerage account on a regular basis, you might not want to listen to Mr. Keyfitz. If interest rates rise, the value of most bond ETFs and mutual funds will go down. While the reverse is true, I much more worried about interest rates rising than dropping.

 

The basic difference between these views is deceptively simple:

Mr. Keyfitz is looking at value of the bonds and future income from interest. Those he criticizes are looking just at the value of bonds.

From Mr. Keyfitz’s perspective, allocating money to individual bonds or bond funds does not affect your total return.  If interest rates rise, the share price of a bond fund goes down however the yield will rise. In other words, the loss of value is compensated by a higher rate of future return. Your asset (the fund or etf) loses value but, you receive a higher yield. From his perspective, these effects cancel each other other.

Personal finance experts are focused on the value of bond and ignore the potential benefits of future income from the fund. Rising interest rates absolutely cause bond funds and etfs to lose value. The longer the average maturity of bonds in the funds (technically, I should say duration), the bigger the impact of an interest rate move. If you’re invested in a typical bond fund (one that holds bonds with 4 to 10 year maturities) a 2% rise in interest rates will shave off around 10% off the value of the  bond fund. If you have five years to wait, the loss on the value of bond fund will be offset by the higher yield. But, if you need to use the money, you will not have the opportunity to make up the loss on the fund’s value.

Individual bonds will fall in value when interest rates rise as well but, as Mr. Keyfitz states in his article, if you hold them to maturity and they do not default, you get your full principal back at maturity.  If you plan to reinvest that principal at maturity, then Mr. Keyfitz is correct that there really is no difference between individual bonds and bond funds.  However, if you plan to spend that money then there is a huge difference.  With the individual bond you know with certainty that, absent a default, you will get that fixed amount of money.  Bond Funds do not provide this certainty, and are therefore riskier than individual bonds when the money is not going to be reinvested.

 

A more technical look:

From Mr. Keyfiitz perspective, a bond fund is just a bunch of individual bonds. While the portfolio manager could hold all the bonds to maturity and receive the bonds face value, he or she will frequently sell shorter dated maturities and replace them with longer dated maturities. When he or she sells the bonds, they usually will not receive the bond’s face value. Depending on how interest rates moved since the purchase of the bonds, and the time that has elapsed since their purchase, the value of the bonds will be different than their face value.

This is the key fact that in his view the personal finance experts ignore.  That just because an individual is holding an individual bond, does not mean that the value of the bond equals its face value. While the bond will equal its face value on maturity (provided no defaults), there are significant opportunity costs (the chance to invest at a higher yield) that are forgone because the bond investor is holding to maturity.

On the other hand, Mr Keyfitz is ignoring liquidity risk. By buying individual bonds, investors are making sure that they have cash at the point when they expect to need it in the future. Otherwise, the investor will have to sell their bond fund at a “low” price without getting the benefits of the higher yield.

The Bottom Line:  If you want to live off the income from your investments, then individual bonds can provide you with the income certainty that most bond funds cannot.

Learn More

How to choose a corporate bond for income
What an Extra 1% Yield on Investment Grade Bonds?
What Happens When a Corporate Bond Defaults?
Should You Trust the Rating Agencies?
How to trade corporate bonds with E*Trade

 


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