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Certain but Risky

Rick Moberg

A POPULAR MYTH holds that individual bonds are safer than bond funds—because individual bonds supposedly come with no interest rate risk.

Proponents of this notion claim that if you buy a bond and interest rates rise—which they have this year—you won’t lose any principal because you’ll eventually get back the bond’s par value, assuming you hold the bond to maturity and the issuer doesn’t default. This is true, but it doesn’t mean individual bonds don’t involve interest rate risk. That myth rests on three faulty legs.

For starters, proponents conflate certainty of results with lack of interest rate risk. It’s undeniable that individual bonds deliver certainty if they’re held to maturity and issuers don’t default. Certainty, however, shouldn’t be confused with an absence of interest rate risk.

That brings me to proponents’ second mistake: They focus on principal and ignore interest. When market interest rates rise, you may get your principal back if you hold to maturity. But in the meantime, you forfeit the higher yields on offer elsewhere.

Let’s assume you purchase a new bond issue at its $1,000 par value. The bond has a 3% coupon and a 20-year maturity. The next day, market rates jump to 5%. The value of your bond would fall to $749 because it now yields $20 less per year than comparable bonds.

Over the next 20 years, you’d forfeit a total of $400 in interest on your $1,000 bond. Proponents can argue that forfeited interest doesn’t count as a loss. The bond market would respectfully disagree with you—and that disagreement is reflected in the lower price you’d get if you need to sell your bond.

What if you sold and reinvested the proceeds in a new bond with a 5% coupon and a comparable maturity date? Your return would be the same. Selling the bond to buy a higher-yielding bond has no economic benefit because the higher interest rate on the new bond would be offset by the capital loss on the old bond.

What’s the third mistake that proponents make? They muddy the role portfolio structure plays in determining interest rate risk. This gets a little complicated, but stay with me here.

Assume Jack builds a portfolio of individual municipal bonds and Diane buys a muni bond fund, both of which have seven-year average durations. After making their investments, interest rates increase by one percentage point, resulting in a 7% price decline. When they log into their respective brokerage accounts, Jack and Diane will see that their bonds are now valued at 93% of their cost. Proponents argue Jack can ignore his loss because it’s temporary, but Diane’s is permanent.

Is Jack really taking less risk? They’ve both incurred an equal unrealized loss and the yield on their portfolios would be identical from that point forward, assuming everything else is equal. In reality, everything else is rarely equal. Besides constantly changing interest rates, another important consideration is portfolio structure. That structure affects duration, which in turn affects interest rate risk.

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Diane’s bond fund likely uses a rolling bond ladder structure, where the fund manager purchases bonds with maturity dates spaced out across multiple years. As the fund’s bonds mature, they’re replaced with new bonds that keep the overall portfolio’s duration relatively constant. If Jack also structures his portfolio this way, his results would be similar to Diane’s, assuming they maintain similar durations.

Alternatively, Jack may use a single maturity structure, where he purchases bonds that all mature about the same time. He might do this because he’s looking to fund a one-time expense, such as his daughter’s college costs. Or perhaps Jack has built a bond ladder structure where he purchases bonds with staggered maturity dates, so he has bonds maturing at regular intervals. As Jack’s bonds mature, they aren’t rolled into new bonds. Instead, he might use the proceeds to fund his annual retirement spending.

In these two structures, duration gradually declines until the last bond matures. If Jack used one of these two strategies, the interest rate risk in his portfolio would start off the same as Diane’s bond fund but would decline over time. Still, declining interest rate risk isn’t the same as no rate risk.

All this leads me to five conclusions. First, held-to-maturity individual bonds deliver certainty and are an effective way to fund known future expenses. Second, comparable bonds held in individual portfolios and bond funds have the same interest rate risk. Third, the interest rate risk in an individual portfolio and bond fund is likely to differ because of different portfolio structures. Fourth, while portfolios of individual bonds may have declining interest rate risk, that doesn’t mean they have no risk.

Finally, if you reject my conclusions—as I suspect some of you will—you can’t escape contingent interest rate risk. The no-interest-rate-risk myth requires buyers to hold to maturity. But what if life intervenes and you’re forced to sell your individual bonds before maturity? Despite your best intentions, you could lose money.

Rick Moberg is the retired chief financial officer of a publicly traded software company. He has an MBA in finance, is a CPA and has a passion for personal finance. Rick lives outside of Boston with his wife. Check out his previous articles.

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Langston Holland
Langston Holland
6 months ago

This is one of the best bonds vs. bond funds summaries I’ve seen, thanks Rick. Of course the lovely thing about funds is that you effectively diversify away the unsystematic risk of individual defaults. If you need or want maturities, you can even purchase low cost bond ETF’s with target maturity dates. Unless you’re able to avoid those low-lifes that fly first class with your private jets, I really don’t see a reason to own individual bonds outside of new-issue treasuries.

Ormode
Ormode
6 months ago

For a bond fund, you have to consider how actions of the other investors might impact your investment. If they panic and sell when interest rates go up and values go down, then the fund managers will have to sell bonds and lock in the loss. If interest rates then go down, and investors return, the fund managers will be buying the bonds similar to what they just sold, but at higher prices. If you just continue to hold, you will lose more money than you would as an individual bondholder.

Jonathan Clements
Jonathan Clements
6 months ago
Reply to  Ormode

In theory, departing and arriving fund investors should transact at a fair market value, so shareholders who sit tight ought to be unaffected, except to the degree that they hold the fund in a taxable account and the fund is compelled to realize capital gains.

David Baese
David Baese
6 months ago

You can offset the interest rate risk with the fixed interest rate on your personal residence. If interest rates go up you can purchase discounted bonds with the same nominal interest rate as your mortgage, in effect prepaying your mortgage at a discount. At the same time the fair market rental value of your residence will increase while your mortgage costs remain the same. If interest rates go down your bonds look good until they are paid off or called, and you can refinance your residence at a lower rate and lower your monthly payment.

Rick Moberg
Rick Moberg
6 months ago
Reply to  David Baese

Perhaps, but only if you have a mortgage. Renters and many retired people don’t.

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