What's the difference between buying bonds and buying bond funds for the long-term?

Question

I know that if I buy a bond and hold to maturity, I will get the value plus the coupon.

If rates go up, the resale value of my bond will go down, and vice versa.

However, what happens if I buy into a long-term bond fund and rates go up? It seems to me that one would expect the price of the bond fund to go down.

If I'm correct, why would anyone in the U.S. buy a long-term bond fund in a market like this one, where interest rates are practically bottomed out?

As an example, take this fund:

Vanguard New York Long-Term Tax-Exempt Fund Investor Shares (VNYTX)

It explicitly says interest rate risk in the description. Is that basically saying that if interest rates go up, the value will go down, and isn't that practically guaranteed considering where rates are historically?

Answer 1

A bond fund will typically own a range of bonds of various durations, in your specific fund:

The fund holds high-quality long-term New York municipal bonds with an average duration of approximately 6–10 years

So through this fund you get to own a range of bonds and the fund price will behave similar to you owning the bonds directly. The fund gives you a little diversification in terms of durations and typically a bit more liquidity. It also may continuously buy bonds over time so you get some averaging vs. just buying a bond at a given time and holding it to maturity. This last bit is important, over long durations the bond fund may perform quite differently than owning a bond to maturity due to this ongoing refresh. Another thing to remember is that you're paying management fees for the fund's management.

As with any bond investment, the longer the duration the more sensitive the price is to change in interest rates because when interest rates change the price will track it. (i.e. compare a change of 1% for a one year duration vs. 1% yearly over 10 years)

If I'm correct, why would anyone in the U.S. buy a long-term bond fund in a market like this one, where interest rates are practically bottomed out?

That is the multi-trillion dollar question. Bond prices today reflect what "people" are willing to pay for them. Those "people" include the Federal Reserve which through various programs (QE, Operation Twist, etc.) has been forcing the interest rates to where they want to see them. If no one believed the Fed would be able to keep interest rates where they want them then the prices would be different but given that investors know the Fed has access to an infinite supply of money it becomes a more difficult decision to bet against that. (aka "Don't fight the Fed"). My personal belief is that rates will come up but I haven't been able to translate that belief into making money ;-) This question is very complex and has to do not only with US policies and economy but with the status of the US currency in the world and the world economy in general. The other saying that comes to mind in this context is that the market can remain irrational (and it certainly seems to be that) longer than you can remain solvent.

Answer 2

Yes, bond funds are marked to market, so they will decline as the composition of their holdings will.

Households actually have unimpressive relative levels of credit to equity holdings. The reason why is because there is little return on credit, making it irrational to hold any amount greater than to fund future liquidity needs, risk adjusted and time discounted.

The vast majority of credit is held by insurance companies. Pension funds have large stakes as well. Banks hold even fewer bonds since they try to sell them as soon as they've made them.

Insurance companies are forced to hold a large percentage of their floats in credit then preferred equity. While this dulls their returns, it's not a large problem for them because they typically hold bonds until maturity. Only the ones who misprice the risk of insurance will have to sell at unfavorable prices.

Being able to predict interest rates thus bond prices accurately would make one the best bond manager in the world. While it does look like inflation will rise again soon just as it has during every other US expansion, can it be assured when commodity prices are high in real terms and look like they may be in a collapse? The banking industry would have to produce credit at a much higher rate to counter the deflation of all physical goods.

Households typically shun assets at low prices to pursue others at high prices, so their holdings of bonds ETFs should be expected to decline during a bond collapse. If insurance companies find it less costly to hold ETFs then they will contribute to an increase in bond ETF supply.

Answer 3

why would anyone buy a long-term bond fund in a market like this one, where interest rates are practically bottomed out?

1. You are making the assumption that interest rates has bottomed out hence there is no further possibility of it going down further, I mean who expected Lehman Brothers to go bankrupt?

2. Long term investors who are able to wait for the bad times of the bond market to end and in the meantime don't mind some dividend payments of 2-3%.