A Bond Mutual Fund or ETF is Riskier than Individual Bonds

Dec 9, 2010
Peter Owen

Investors in Bond Mutual Funds and ETFs do not Understand that these Commingled Investment Vehicles do not Mature as do Individual Bonds

Popularity and Complacency of Bond Investments

Investing in Bonds and Bond Funds has been extremely popular for many years as interest rates have dropped, causing the market value of these investments to increase. Also, the common investor has had an increasing aversion to the Stock Market. These investors constantly hear and read that bond prices move inversely to interest rates. When interest rates go up, bond prices go down, and conversely, when interest rates go down, bond prices go up. This fact affects all bond investments including individual bonds, and bonds held in Commingled Investment Vehicles such as Bond Mutual Funds and Bond Electronically Traded Funds, or ETFs for short.

The general public is pouring more and more money into these funds since they believe the individual bonds and bond funds to be relatively safe investments versus investments in the stock market. People have not experienced a large drop in the market value of their bond investments over the years since interest rates have kept dropping while the stock market has been much more volatile. The complacent investor views the bond market as a safe place to have his or her money.

Individual Bond Portfolio

Holders of individual bonds, including Treasury Bonds and Corporate Bonds, may or may not be aware that they will experience a loss in the market value of their investments as interest rates increase in the future. It is a fairly common view in the investment community that interest rates will go up in the future as inflation increases, resulting from the global economic recovery and spending patterns of the US Congress. The holders of individual bonds are not very concerned since they can just keep the bonds until maturity when they will get their full par value back. This is true and many ordinary investors will do this since many people view their bonds in much the same was as they view a Certificates of Deposit. They will let the bonds mature and reinvest the proceeds in new bonds or CDs.

Bond Funds and Bond ETFs

Investors in Bond Funds do not own specific bonds; they own a portion of every bond in the fund. The majority of Bond Funds have no maturity date. If such a fund has the objective of holding 10 year bonds, the manager of the fund will ensure that the average maturity of all the fund holdings is roughly 10 years at all times. In these funds, previously purchased bonds are maturing almost every day and any such holdings are reinvested in new 10 year bonds at then current interest rates. Since the investor owns a portion of every bond in the fund, his investment will never mature. An investor who today invests in a 10 year bond fund will not receive full par value 10 years from now.

Individual Bonds versus Bond Funds

If an Individual Bond holder needs to withdraw his investment prior to maturity, he will experience a market value gain or loss, depending upon the level of then current interest rates. This also applies to the holder of a Fund. However, relative to the holder of a Fund, the magnitude of the gain or loss for the individual bond holder will be reduced each year as the bonds get closer to maturity. If an investor had bought a portfolio of 10 year bonds in year 2000, the bonds in this portfolio would be maturing in 2010. If an investor had placed his money in a 10 year bond fund in year 2000, this year he would still be holding a fund containing bonds with an average maturity of 10 years.

As interest rates rise, investors in bond funds are going to experience a market value loss. Such a loss cannot be avoided by continuing to hold the investment, as can occur with the individual bond holder, unless and until interest rates return to the level at which the investor entered the fund.

Consider Buying Individual Bonds

Investors in bonds should consider buying individual bonds rather than investing in bond funds so that they are less exposed to potential market value losses in the future.