It's common to read or hear stories about how we should be avoiding bond funds right now because interest rates are going up. If interest rates go up, they say, you will surely lose money in your bond funds. So if you shouldn't be investing in bond funds, what are you supposed to do? The "experts" would have you think it's better to invest in individual bonds. Let's talk about this illusion.
Interest Rate and Bond Price Relationship
The circus that's telling you to avoid bond funds because interest rates are going to rise have some evidence behind them. There is an inverse relationship between interest rates and bond prices. Let's think about why. If I have a bond that matures for $1,000 and pays 5% interest, and tomorrow interest rates go up to 6%, that sucks for me. If I need to sell this bond, nobody is going to pay me $1,000, and that's because for the same $1,000 they can buy a bond that pays them 6%. In order to entice people to buy my bond I have to lower the price. The price drops so that the buyer is indifferent between buying a 6% bond for $1,000 and buying a 5% bond for something less than $1,000.
The argument for investing in individual bonds over bond funds goes like this: If your money is in a bond fund, and interest rates go up, then your bond fund's price is going to fall and you lose, sucker. If, instead, you had an individual bond and interest rates went up, the price of your bond would fall, but you wouldn't care because if you hold the bond until maturity you get the whole value back.
This makes sense on the surface. You often hear this from the media - who have an interest in tugging at your fear and greed strings because their sponsors need you to trade. You'll also hear this from investment managers - who want you to think investing is hard so they can do it for you and justify charging you 1% of your assets. Consider these sources.
When people bring up rising interest rates they always talk about the fact that bond prices go down. They never add the caveat, "in the short run," like they should. Because eventually those prices will rebound. How do I know that? Because interest rates went up! That's right, people forget that when interest rates go up, you get more interest. This seems to be lost on folks or intentionally left out to keep consumers confused.
Don't Forget About Forecasting
Before I talk about how bonds and bond funds perform exactly the same when interest rates rise, let's talk about these forecasts. People have been saying for years that interest rates are going to go up. They have a little bit, but rates can stay low for a long time. Remember, nobody can forecast the future better than the markets can. If the market anticipated interest rates were going to rise, prices would adjust to anticipate this. Predicting the future is a fools errand.
When interest rates rise, as we've learned, the prices of our bond funds fall immediately. This makes sense, because of the inverse relationship between prices and interest rates. However, after those prices fall, the bond funds get to start investing new money in bonds that have higher interest rates. Bond funds regain a lot of their lost ground because, going forward, they make up for it with bonds that pay out more.
Now, it's true that when interest rates rise and you are holding onto an individual bond, you'll get your par value back at maturity. Remember, and this is important, your money is invested at lower rates than you could otherwise get! So even though you don't lose money and get your money back, you have an opportunity cost in the form of lost interest. The net result is that bonds and bond funds perform exactly the same due to interest rate changes.
Think of it this way, when interest rates go up and you have a bond fund, you feel that pain immediately, the same way you would ripping a bandage off very quickly. When rates go up while you are holding an individual bond, you feel the pain very slowly over time, as if you were peeling the bandage off very slowly. Either way, it's the same thing.
Not All Funds Are Created Equal
Now, even though I sound like I'm pro bond funds (which I am), I should note that there are particular instances where it doesn't make as much sense to buy a fund. Buying CDs or Treasury securities, for example, would not require a fund because these are backed by the government and don't require diversification. There are other cases where people need to have more control over their duration and again, in that case, investing in individual securities can be better. Having said that, some people don't want to go buy new CDs, Treasuries, or other bonds every time one matures, so for those folks funds still make a lot of sense.
Rick Van Ness: Why Bother with Bonds
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