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An article yesterday by David Lancaster detailing his bond fund investments going pear-shaped during the 2022/23 bond market crash got me thinking about what I have actually learned from this costly experience that took many of us by surprise.
Like David, I perceived bond funds as a “safe” or “stable” investment, assuming they behaved like individual bonds held to maturity. The recent downturn, however, exposed my lack of understanding. When rates rose rapidly, the market value of the bonds within the funds dropped. Since bond funds are perpetual and do not “mature” to par, investors saw the value of their fund shares decline.
My key takeaway was my lack of personal education. This, in my opinion, underscores the importance of understanding the precise mechanisms of any investment product, not just its broad asset class, to really grasp its risks and potential behavior in different market conditions. I failed with this and paid the price. Unfortunately, it was a costly lesson learned, but if nothing else, I have now had a practical demonstration of why I need to understand what I invest my money in.
My second takeaway: buying individual bonds in a bond ladder and holding to maturity is an effective strategy to navigate this risk. Holding an individual bond to maturity ensures you receive your original principal back. Daily price fluctuations become irrelevant if you do not intend to sell. Unlike my previous bond funds, which continuously rebalanced and reflected current market values, holding individual bonds isolates me from market volatility for that specific bond. I concede this will work better for short to medium term time frames and this is how I will be using them.
While buying individual bonds has definitely required more effort on my part, they offer me predictability and principal return at a defined date. That is a stark contrast to the bond funds in my portfolio during the recent downturn. My “buy and hold” approach to individual bonds has given me a path through interest rate turbulence, although inflation risk is still an issue. As a side note, there’s a fantastic online tool for building UK government bond ladders. I don’t think I would have managed without it.
Quite possibly over the coming years other nasty investment surprises will rear their ugly heads. My hope is I am now in a better position to insulate myself from these “unknown unknowns” by only investing in things that I clearly understand. I think this philosophy can be extended to other asset classes whether it’s equities, real estate, commodities, or alternative investments. I definitely intend to double down on my education and hope for the best.
You might want to think in terms of real returns (backing out inflation). A lot of times getting back your principal after 5 years is a loss on a real returns basis.
You aren’t avoiding the loss by buying the ladder, you’re just making it invisible except when you go to purchase an item.
Individual bonds lost value as well. Yes, if you held until maturity you would not have lost any money…just the increased dividend/interest that you lost by holding bonds paying less in interest. Its all relative.
There’s a really good article from Jonathan in the money guide section that talks about this choice and the illusion of staying whole in individual bonds. Can’t find it right now, sorry.
Perhaps you’re referring to this article?
Yes thanks, that’s the one.
Has anyone used any of the Target Date iBond ETFs? If so, I’d love to know your experience.
The expense ratios on the iBond Target Date Maturity ETFs range from 7 basis points for U.S. Treasuries;10 bps for TIPS, Municipals, & Investment Grade Corporate; and 35 bps for the “High Yield & Income Corporate” ETF.
7 – 10 bps seems a very reasonable price for increased diversification and professional purchasing and management. Anyone care to comment?
Mark, I wish I had read this before posting the following question on David’s post;
In this situation, would it make more sense to purchase individual bonds with maturity dates that match your desired time frame?
Dan, I think you possibly know what I’m about to say. For my situation and my circumstances, I definitely think it was the right choice. I now prefer duration-matched government bonds over bond funds to mitigate interest rate risk, but there’s obviously still the inflation cost over longer timeframes. Are they right for you? Possibly, but that’s a very personal call.
Every investment entail risk, and I concluded that bond funds were risky. In 2020-2021 I sold 90% of my bond funds and switched to individual bonds. The few bond funds I do own remain at a loss, even with reinvestment. A tips fund shows a loss of 2.77% although looking at the purchase price in 2020 there is a gain of 15%. The shares purchased via dividends to date are not worth what was paid for them. In fact the losses was a pittance and a fraction of a percent with negligible impact on the value of the portfolio.
If you reinvested the interest income distributions from your original bond funds would you still have losses today?
In my case as I wrote earlier this week I have gained 1/2 percent in. 5 1/2 years due to dividends, so I didn’t lose my initial investment, just basically broke even. But as long as I live 7 years more (very likely as I’m only 67) I will essentially recoup my capital losses in yearly 3K bundles through my tax return deductions.
In my case, yes. I know because I’ve still got the bond fund in question; I’m holding off selling until I move out of the red. The bond ladder was created with some of the funds from a business sale.
Instead of the risk assiciated with individual bonds, can anyone comment on their use of iShares iBond target date ETF funds? Seems like the best of all worlds with the advantages of “hold to maturity,” low fees, and diversification of risk with many bonds of similar maturity date held in an ETF — as far as I can tell. For those not familiar: https://www.ishares.com/us/strategies/bond-etfs/build-better-bond-ladders
I have not made any purchases of the Black Rock or Invesco target date ETF funds, but the products seem reasonable. What I couldn’t figure out from the literature was how PAR value at maturity was calculated. I called Black Rock and they said all their iShares products have a target NAV of about $25 at maturity. Apparently it is difficult to normalize the price of the basket of bonds in the fund to exactly $25. My other observation is that excepting Treasuries, the funds do not have products that extend much beyond 5 years – including TIPS, corporate, municipals and high yield.
I will probably test drive one of the products later in the year.
From reading the literature, it seems like an innovative product. Personally, I think I would have used a fund like this over the bond ladder I’ve built if I had been aware it existed. The biggest possible disadvantage of iBonds (Target Maturity ETFs) that I can think of, compared to owning actual bonds in a ladder, is the ongoing expense ratio. I guess it’s a personal preference whether the convenience is worth the cost.
In our case, our bond mix was half funds/ETFs and half laddered individual bonds (Treasury Inflation Protected Securities=TIPS). In 2022, the funds/ETFs were down 10%, however it also was a year of high inflation so the TIPS kicked off significant interest income which softened the blow of the the hit to our stock and bond funds/ETFs along with a small allocation to a commodities fund. I believe overall we were -2% for the year. Our TIPS ladder is a 10-year rolling ladder which we hold to maturity also. Individual TIPS are not ideal when held in a taxable account but they are the one asset guaranteed to retain purchasing power if held to maturity. This approach was designed by our FA who fortunately is also professorial and takes the time to explain. I have also invested a good bit of time in self education over the last 10 years but I also realize I know very little and just enough to be dangerous.
Amen to your closing thought! It sounds like your FA definitely proved their worth, especially with that TIPS strategy in 2022