AT THE MUTUAL FUND company where I once worked, the stock and bond teams liked to poke fun at one another. Bond managers viewed the stock-pickers as overpaid storytellers. Meanwhile, the stock-pickers saw the world of bonds as stultifying. “Playing for nickels and dimes” is how one of them put it.
For better or worse, bonds do indeed represent the slow lane. But this year, with bond prices depressed by rising interest rates, investors are wanting to learn more. Below are the seven questions I’ve been hearing most frequently.
1. Bonds are down some 10% in 2022. How do I think about risk? The trickiest thing about bonds is that they carry two entirely separate types of risk. The first is called credit risk, and it’s the easier one to understand. This represents the risk that a bond issuer might fail to make all its required payments. When this happens, it’s called a default. The result is usually a sharp decline in the bond’s price.
When Enron went bankrupt, for example, its bonds declined to 17 cents on the dollar. With only a few obscure exceptions, though, the U.S. government has never defaulted on its debt. For that reason, these are the bonds I recommend most frequently.
But as we’ve seen this year, even U.S. government bonds can decline in price. That’s because of the second category of bond risk, known as duration risk.
The duration formula is somewhat involved. But in short, it’s a measure of how long it’ll take investors to get their money back. The longer the duration, the longer the wait. The problem with waiting: When rates rise, newer bonds sporting higher rates become more attractive. That depresses the price of older bonds with lower rates. The longer a bond’s duration, the longer its owner is stuck with that lower rate. That’s why bond prices drop when interest rates rise, and why bonds with longer durations experience larger declines.
A good rule of thumb: When you invest in bonds, align the duration of those bonds with your timeline for needing those funds. Saving for a home down payment next year? I’d opt for a duration of a year or less. You can find bonds of virtually every duration.
2. What about international government bonds? Don’t they pay higher rates? This is a reasonable question. I don’t worry about major developed countries defaulting on their debt. But there’s another problem: currency fluctuations. Because bond yields are so thin, it’s easy to lose money on a foreign bond just because the dollar strengthens a little.
3. Will bond prices keep dropping? What we’ve seen this year is unnerving. But keep in mind that a bond is just like any other investment: If its price has dropped, it now represents better value, all things being equal.
Yes, the Federal Reserve could continue raising rates. The Fed has indicated it plans to do so, and that would put further downward pressure on bonds. But here’s the key thing to keep in mind: Rising rates also have a silver lining. If you’re invested in a bond fund, the fund manager is now able to buy new bonds with more attractive rates. Those higher interest payments will help offset losses you experience if bond prices fall further. Eventually, you’ll reach a breakeven point. How long will that take? Again, duration is important. The longer the duration, the longer it will take to break even.
4. Does that mean you should only ever invest in short-term bonds? No. Historically, the vast majority of the return from bonds has come from interest payments and not from price changes, so it can be worthwhile to own longer-term bonds if they’re paying more. Today, however, longer-term bonds aren’t paying much more than shorter-term bonds, which is why I’m happier with short-term bonds right now. But this situation won’t last forever. As a bond investor, I think it makes sense to diversify between short- and intermediate-term bonds.
5. A bond manager is promoting rates of 5%—much higher than prevailing rates. How is that possible? When you buy a stock, it’s straightforward. If the price is $100, you pay $100 and hope it goes up. But with bonds, it’s more confusing. Bonds have a face value—usually $1,000. But they’ll often trade at either a premium or a discount—that is, higher or lower than the face value. Regardless of what you pay, though, the bond will still only pay $1,000 at maturity.
This is a reason to be careful. Don’t be misled by the coupon payments a bond offers. That represents just one part of a bond’s return. The other component is the difference between what you paid and the $1,000 you receive at maturity.
Let’s come back to the fund manager trumpeting that 5% interest rate. What’s actually going on? The bonds do indeed pay 5% coupons. But in the current environment, with rates closer to 3%, bonds paying 5% will be trading at a premium, meaning they’ll cost more than $1,000.
Consider a simplified example. A bond offering a 5% rate, with one year to maturity, might cost $1,020. What will happen over the next year? You’ll collect a 5% interest payment. But at maturity, you’ll receive only $1,000, not the $1,020 you paid. That represents a 2% loss. Thus, the net return will be 3%, not 5%.
The lesson: Don’t be distracted by the interest rate on a bond. What you want to look at instead is its yield to maturity. That represents the net return investors will actually receive—3% in the above example.
6. If yield to maturity is what’s important, what does it mean when mutual funds report their distribution yield or SEC yield? These are confusingly similar terms. If you’re looking at an individual bond, its yield to maturity is the most useful figure. But if you’re looking at a bond fund, you may see only its distribution yield and its SEC yield.
I wouldn’t put much stock in distribution yields. First, they’re backward-looking. They extrapolate from past income distributions. In a normal environment, that might be reasonable. But when rates are rising, as they have this year, it makes no sense to extrapolate from past returns. Further compounding the issue: Fund companies each calculate this figure differently, making it minimally useful for comparing investment options.
The SEC yield, on the other hand, does provide a common yardstick for comparing bond funds. While it too extrapolates from a fund’s recent income, it does so in a more meaningful way. In addition, it accounts for a fund’s internal expenses. That’s why, if you’re looking at a fund, this is the figure I’d consult.
7. Should I own individual bonds or a bond fund? In theory, the performance of a bond fund should simply be the aggregate of all of the bonds it owns. For that reason, there shouldn’t be much difference between the performance of an individual bond and the performance of a fund that holds a group of comparable bonds.
There’s one caveat, though: When you’re a shareholder in a mutual fund, it’s like sharing an elevator with a group of strangers. Everything should be fine—as long as everyone behaves. In the context of a mutual fund, what does it mean for other investors to behave? You want them to be patient, especially when the fund is having a tough year, like this one.
What happens if fellow investors pull out of a fund after it’s dropped? The fund manager may need to sell some of the fund’s holdings to raise cash. That would disrupt the portfolio, trigger trading costs and perhaps lead to larger tax bills for the shareholders who remain.
In ordinary times, I have no problem with bond funds. In fact, they offer a number of advantages. In today’s environment, however, there’s no guarantee that everyone on the elevator will cooperate. For that reason, I think individual bonds make more sense than in the past.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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Newbie question, wouldn’t neighbor risk apply to Bond ETFs (bid:ask spread) and not Bond Mutual Funds?
https://www.bankeronwheels.com/are-bond-etfs-safe-fed-smccf-lqd-vcit-vchs-hygjnk/ & this one doesn’t really address the question but good background https://www.bogleheads.org/wiki/Individual_bonds_vs_a_bond_fund
Always enjoy Adam’s articles.
FYI, in an addition to my investment vocabulary, I recently heard the risk of fellow fund shareholders not behaving called “neighbor risk.”
Very informative summary Adam, and I particularly found item number 7 interesting. In recent years, I struggled with choosing between bonds and cash for my non-equity holdings. For the reasons you cited, I have favored primarily money market funds and CDs over bonds.
Adam, another great post. How can a bond fund investor determine the percentage of holdings are held to maturity and then reinvested? The turnover rate for vanguard’s total bond fund is 69%. I know redemptions could drive some sales, but would hope most fund holdings would simply be held to maturity and then reinvested.
Adam, great information and timely as bonds are becoming a more interesting investment option now that yields have moved off zero. Wondering about bond ETFs versus bond mutual funds. Doesn’t the ETF buy/redemption structure cure the problem you stated with a mutual fund?