6

I have heard this argument several times.

Today's low-interest rate environment makes it risky to own bond funds/ETF. Investors will be seriously injured when interest rates start rising because funds/etfs have no maturity date. It’s much safer to own individual bonds and simply hold them to maturity. That way, investors are assured of getting their principal back and not taking any losses.

What are some counter-argument to this argument? It sounds logical but something seems to be missing. After all, bond funds/ETFs hold individual bonds. So, why should bond fund/etfs be riskier than individual bonds? I can't put my finger exactly at it.

Does buying individual bonds really offer a substantial risk advantage over bond funds/etfs?

6

I wrote about this a while back, and it boils down to risk profile.

If you hold the bond to maturity, then you minimize your capital risk: if you bought a $1,000 bond, once it matures, you are guaranteed the capital back (i.e., your $1,000).

However, with a bond ETF, because the ETF is made up of underlying bonds, if interest rates go up, the aggregate value of the ETF will go down. Say you have an ETF with a single bond, and assume:

Semi-annual payments of $25 (i.e. 5% on $1,000 par)
Market rate for bonds is 3% per annum

If there are 5 years remaining, the bond at 3% will be worth $1,092.22 (assuming no other fees). If interest rates instantly move to 4%, the bond suddenly drops to $1,044.91. So if you bought the bond in the morning, and sold it in the afternoon, you have suddenly lost $47.31. This scales up with multiple bonds, since they are all affected by market interest rates.

Contrast this with your bond: you are guaranteed to get back your $1,000, regardless of the movement of interest rates. However, while you have minimized loss of capital, you have now emphasized reinvestment risk. Going back to our example, if you paid $1,092.22 for the bond, that assumes prevailing rates of 3% on your 5% coupon bond. If rates suddenly jump to 4%, but your money is locked in at 3%, you are now missing out on 1% in returns elsewhere.

So it comes down to risk profile: you trade one risk for another. In the example above, you may have lost $47.31, but now you can take the money from the sale and re-invest that in something offering a 4% return.

  • 1
    Good answer - I think one thing could be emphasized based on what appears to be a misunderstanding from the OP: s/he states that a bond fund 'has no maturity date'; however it does really have an 'aggregate average' maturity date based on the bonds held in the fund. So if interest rates go down, the immediate value of a pre-existing bond fund would still go up the same as an individual bond. The difference would be that the bond fund would continue to purchase new bonds at the lower interest rate, thus averaging down the total interest rate over time. – Grade 'Eh' Bacon May 29 '17 at 14:04
  • Could you please explain why a 5-year stream of semi-annual payments of $25 each is worth only $92+ today? Thanks. – Dilip Sarwate May 29 '17 at 20:21

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.