In a rising interest rate environment, it may be better to hold a bond fund than a few individual bonds. Here is the math that supports the argument.
Experts have been telling investors to sell their bond funds and if they want fixed income exposure, to buy individual bonds, because this will protect investors from rising rates. Intuitively, it makes sense, as if you own a bond and interest rates rise, the bond’s value declines. But, if you hold the bond until maturity, eventually, you recoup 100 percent of the principal.
The following is a comparative example: You hold a 10-year bond, which you bought for $1,000. It pays a 2 percent dividend. After you buy the bond, the interest rate on equivalent 10-year bonds rises to 4 percent. This makes the original bond’s value decline to $836. You can continue to hold the bond and earn 2 percent and receive the $1,000 principal until maturity.
Now suppose a mutual fund whose managers actively buy and sell bonds incurs the same situation. The fund’s managers choose to sell the bond for $836 and invest the proceeds in a new 10-year bond that carries a 4 percent coupon. The fund’s managers take the proceeds from the sale of the 10-year, 2 percent bond, which is $836, and buy a 10-year bond with a 4 percent coupon. Since the fund only has $836, the managers can only purchase a portion of a $1,000 bond, which equals $836/$1000 or 83.6 percent. This new bond’s dividends are $33.46, not $40, as the fund owns only $836 of this bond. Upon maturity, the bond fund receives $836.
In either scenario, the IRR (internal rate of return) is the same – 2 percent – if you hold the individual bonds or invest in a bond fund, assuming the durations are equivalent. However, due to selling the bond, the seller can take a capital loss at the time. By using a fund as opposed to individual bonds, an investor ends up with a diversified portfolio of many bonds, and transaction costs, which can be expensive in the retail market, are minimized. In addition, a savvy bond fund manager may be able to find valuable bonds at more reasonable prices than an individual investor can.
Over time, the bond fund’s managers continue this buying and selling practice. The bond fund’s yield continues to rise and eventually offsets the initial price decline that occurred when interest rates rose.
Disclaimer: The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisers before investing.