Bond funds and how they differ from bonds

The difference between holding a bond and holding a bond fund is the reason so many investors were surprised by bond fund losses during periods of rising rates.

The core difference

Which explains most of the confusion.

An individual bond held to maturity returns the principal on a known date, and the return is known in advance absent default.

A bond fund holds many bonds of varying maturities, continuously reinvesting proceeds as bonds mature.

Which means the fund has no maturity date and no point at which principal is returned.

The fund's value reflects the current market value of its holdings, which moves inversely with yields.

What happens when rates rise

The sequence.

Existing bonds fall in value, so the fund's price falls.

Maturing bonds are reinvested at higher yields, so the fund's income rises over time.

Which means a rate rise produces an immediate capital loss followed by higher future income.

For an investor with a horizon longer than the fund's duration, the higher reinvestment yields eventually more than compensate for the initial loss — which is the theoretical justification for holding through it.

For an investor needing the money sooner, the loss is realised.

Duration as the key measure

What it tells you.

Duration approximates the price sensitivity to a change in yields.

It also approximates the point at which the capital loss from a rate rise and the gain from higher reinvestment yields offset each other.

Which means matching the fund's duration roughly to your investment horizon reduces the interest rate risk to the outcome, a technique known as duration matching.

A fund with a duration of seven years held for seven years is substantially insulated from a one-off change in rates, in theory.

The fund types

Which behave differently.

Short-duration funds, which move little with rates and offer lower yields.

Intermediate funds, the most common core holding.

Long-duration funds, which are highly rate-sensitive and which produced substantial losses during rate rises.

Aggregate funds holding a mix of government and corporate bonds.

Corporate bond funds, with more credit risk and more equity-like behaviour during stress.

High yield funds, which behave substantially like equities during stress and do not provide the diversification most people hold bonds for.

Emerging market debt, with currency and political risk.

And inflation-linked funds, which protect against unexpected inflation and retain sensitivity to real rates.

Target maturity funds

A hybrid worth knowing about.

Funds holding bonds all maturing in a specific year, which then return capital and close.

Which restores the maturity date that ordinary bond funds lack, while retaining diversification across issuers.

Useful for matching a known future liability.

Available in some markets and not others.

Yield measures

Which are frequently confused.

Running yield or distribution yield: the income as a percentage of current price, which says nothing about capital.

Yield to maturity: the total return if all bonds are held to maturity, which is the more informative figure and which is the best estimate of a bond fund's expected return over a period roughly equal to its duration.

Which means the yield to maturity at purchase is a reasonable guide to what a bond fund will produce, and the distribution yield is not.

Credit risk

The other dimension.

Government bonds of high-quality issuers carry minimal default risk and are what provide diversification against equity falls.

Corporate bonds carry credit risk and their spreads widen during stress, meaning they fall when equities fall.

Which means holding corporate bonds for diversification against equities is partly self-defeating.

The purpose of the holding should determine the credit quality: diversification argues for government bonds, income may argue for corporate.

Currency

A practical point.

Currency volatility typically exceeds bond volatility substantially, which means unhedged foreign bond funds are dominated by currency movement.

Which defeats the purpose of holding bonds for stability.

Currency-hedged share classes are the standard choice for bond holdings, and checking which you hold is worthwhile since it is easy to hold either accidentally.

Practical selection

For a core bond holding.

High-quality government or aggregate bonds.

Currency-hedged to your own currency.

Intermediate duration, or matched to your horizon.

Broadly diversified across issuers.

Low cost.

And held with the understanding that it can fall in value, which is the expectation that prevents selling at the wrong moment.

The alternative

Worth mentioning.

For shorter horizons and modest amounts, cash deposits provide stability without duration or credit risk, within protection limits.

Which in some rate environments is a reasonable substitute for the stability portion of a portfolio.

And which does not provide the diversification benefit that government bonds have historically offered during equity declines.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.