Fixed interest bonds and bond mutual funds are different, and it matters. This first of two facts helps explain the main difference:
Fixed interest bond values change inversely with changes in prevailing yields.
This fact raises three questions:
- What is the importance of “fixed” interest? The relationship between bond values and prevailing yields only applies to “fixed” interest bonds. In contrast, some bonds change the interest they pay, so the relationship does not apply to them (or as much). For example, variable rate bonds pay interest linked to an interest rate benchmark. When the benchmark value changes, so do the bonds’ interest payments.
- What are “prevailing yields”? These are yields investors can earn from similar bonds. Say you bought a four-year corporate bond two years ago at par[i], its annual interest payment equals 1.80%[ii], and it will mature in two years. After you bought the bond, prevailing yields increased. If you buy a bond like yours today maturing in two years, its yield is the prevailing yield, which was around 2.60% in early February.
- How sensitive are bond values to prevailing yield changes? The best answer appeals to “duration,” the correct measure of bond sensitivity to prevailing yield changes.[iii]Duration depends on yields and the timing of principal and interest payments. A 20-year bond that pays 3% interest has about a 15-year duration; a similar 10-year bond paying 3% has about a 9-year duration. The 20-year bond is more sensitive because its duration is longer. From a different perspective, a sudden 1% yield increase from 3% would push down the 20-year bond value by about 14%; the 10-year value would fall about 8%. If everything else is equal, higher paying bonds and bonds with shorter maturities are less sensitive than lower paying bonds and longer maturities.
Here’s the second fact:
Bonds return all principal upon maturity.[iv]
Getting back to that old 1.80% bond, we checked its value today. It is worth only 98.46% of the principal repayment due in two years; it will pay $1,000 upon maturity, but now it’s only worth $984.60. It trades at a discount. After all, nobody wants to pay full price for a 1.80% bond when similar bonds yield 2.60%. That discounted value might make you uncomfortable if you paid a higher price, but upon maturity, you will receive full payment; the value will eventually rise to 100%, the par value, even if prevailing yields increase![v] This payment is backed by the creditworthiness of the bond issuer.
The guarantee of full principal payment explains the main difference between fixed interest bonds and bond mutual funds: You don’t get that guarantee by owning bond mutual fund shares. When prevailing yields rise and bond values fall, shareholders accelerate redemptions. Redemptions force fund managers to sell bonds and raise cash. Redemptions can leave remaining shareholders with lower valued bonds, less yield, and greater sensitivity to future yield changes:
- The bonds sell at a loss because managers purchased the bonds at higher prices when interest rates were lower. Remaining shareholders share in the losses passed on to them.
- Managers might sell bonds with higher coupon rates and shorter durations because their prices have generally fallen less than lower paying and longer bonds; managers aim to minimize losses. Consequently, the remaining average portfolio yield can decrease and/or average durations (sensitivity to future prevailing yield changes) can increase.
For most of the last 40 years, the difference between bonds and bond mutual funds didn’t matter much. The “10-Yr Treasury Yield” graph illustrates why.[vi]
Almost all bond funds performed well during this period as yields dropped from 15.4% in 1981 to 1.37% in 2016; pressure on managers to sell bonds has been short-lived and infrequent.
Many people think prevailing yields will rise more than they have since 2016, even though nobody knows how much they will rise or for how long. We expect bond owners to recover principal regardless what yields do. If yields rise a lot or quickly, we don’t expect bond mutual fund shareholders to fare as well as bond owners.
[i]“Par” is the principal amount paid upon maturity.
[ii]A bond’s “interest rate” here means its coupon rate, which is the annual coupon (interest) payment in dollars divided by the bond’s par value in dollars. For example, a typical bond would have a $1,000 par value. The 1.80% bond in the example pays an $18 coupon annually, so $18 / $1,000 = 1.80%.
[iii]Go here to see the Macaulay duration equation: https://www.investopedia.com/walkthrough/corporate-finance/3/bonds/duration.aspx. Excel has duration functions investors can use to calculate individual bond durations. Also, Morningstar.com reports durations for most bond funds.
[iv]This assumes no imminent threat to the issuer’s solvency.
[v]If you paid a premium for the bond – more than 100% – then you incur a loss based on the difference between the price you paid and 100%. You would have known exactly the amount of the loss when you bought the bond.
[vi]The 10-year Treasury yield serves as a benchmark for domestic interest rates; other yields have changed about the same way.