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Myth Busters: Bond Market Edition

In a rising rate environment, is it safer to hold individual bonds or bond funds?

Michael Rawson, CFA, 06/26/2013

Market pundits have been expecting interest rates to rise for the last several years. When rates rise, many investors seem to think that bond funds are worse than individual bonds. The thinking goes that since you can hold an individual bond until maturity, you're insulated from the effects of rising interest rates and can avoid taking any losses. A typical bond fund doesn't hold bonds until maturity, forcing it to take losses after interest rates rise.

Inverse Relationship: When Rates Rise, Bond Prices Fall
Let's walk through the math of bond pricing. The present value of a payment to be received in the future equals the value of the payment divided by one plus the interest rate compounded over the appropriate number of periods. This process is called discounting. Since the interest rate is in the denominator, bond prices have an inverse relationship to interest rates. Bond prices are equal to the present value of future coupon payments plus the present value of the par amount or face value paid at maturity.

Assume that market rates are 2% and we have a newly issued 10-year bond paying 2% interest with a par amount of $1,000. (Technically, this bond would pay two semiannual coupons of $10.) Discounting these coupons and the par amount at the market rate of 2% results in a price of $1,000. If market rates jump to 4% on the very next day after you buy this bond, we must now discount all future payments at 4%, resulting in a net present value of $836. So as market rates rise, bond prices fall. The new price of $836 represents a loss of $164 or a 16.4% capital loss. Of course, if we hang on until maturity in 10 years, we get our $1,000 back and earn our original 2% over the life of the bond.

Holding on to our old bond will earn only 2%, but market rates are now 4%. Instead of $20 in annual coupons, a newly issued bond would pay $40 or an additional $20 more in coupons than the old bond. The present value of this additional $20 in coupons over the life of the bond is $164, exactly equal to the loss on the old bond. Since a newly issued bond would be worth $164 more in present value terms, the old bond must offer an equivalent discount to lure a buyer.

What will our return be, taking into account our capital loss, if we sell the bond and use the $836 proceeds to buy a new bond yielding 4%? Since the proceeds from the sale of the old bond are $836, we could only afford to buy 83.6% of a newly issued $1,000 par bond that pays 4%. Instead of $40 in annual coupon interest, we would receive 83.6%, or $33.46. This is still more than the $20 in annual coupons from our old bond. The final pay off at maturity would be $836 or 83.6% of $1,000. The internal rate of return of this stream of payments is 2%. So if we sell the old 2% bond and buy a new one yielding 4%, we end up earning 2%. No matter if we hold on to the old bond or sell it and reinvest the proceeds in a new bond, we still earn 2%. Yes, you take a capital loss on the sale, but selling gives you the opportunity to reinvest at a higher rate, offsetting the capital loss.

A bond fund will not always hold bonds to maturity, as it has to buy and sell bonds to meet fund redemptions or to track an index. But as we have seen, it does not matter if we hold a bond fund or an individual bond when rates rise, all else equal. Assuming they both have the same duration, they will be impacted equally by a rise in rates. Neither holding a bond directly or through a fund will allow us to easily avoid the rise in rates.

My colleague Christine Benz wrote on this same topic and Matt Tucker, head of iShares' fixed-income strategy team, offered the following explanation: "Some investors prefer individual bonds over mutual funds as they believe that bonds protect them from rising interest rates. If rates rise then the price of the bond falls, but the investor can hold the bond until maturity and receive their expected income and principal. A traditional bond fund or exchange-traded fund is perceived as more sensitive to rate moves as it doesn't have predefined income or principal payments. What many investors miss in this analysis is that when rates rise, the income coming from a bond fund or ETF generally increases, while a bond's income is fixed. Over time, the higher income paid out by the fund or ETF compensates an investor for the initial price decline they realized when rates rose initially."

Michael Rawson, CFA is an ETF Analyst with Morningstar.
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