What Is a Bond Fund?
Bond fund is a pooled vehicle holding many bonds, which an investor buys shares in rather than owning the bonds directly. Unlike an individual bond it has no maturity date, so a loss caused by rising rates has no date at which it mechanically returns to par.
A bond fund and a bond are related the way a river is related to a bucket of water. The contents are the same and the behaviour is not, and the difference decides what happens when rates move.
How it works
The fund holds a portfolio of bonds and you hold shares in the fund. You do not own any particular bond, and no bond in the portfolio is earmarked as yours.
The portfolio is maintained rather than held to maturity. As bonds approach their redemption date they are usually sold and replaced with longer-dated ones, keeping the fund’s duration roughly constant.
An individual bond has a date on which you get 100 back, whatever happened in between. That date is the reason a rate-driven loss on a bond is temporary if you hold it.
A fund has no such date. There is no point at which the fund pays you par, because the fund is not maturing — it is perpetually rolling.
What that means for a loss
A bond fund down 12% on a rate rise recovers only if something else happens. Rates fall again, or the higher coupons the fund now buys accumulate enough over time to make up the difference.
Neither is a mechanism, it is a hope with a plausible basis. The individual bond’s return to par is a contractual certainty; the fund’s recovery is a forecast.
The counter-argument is genuine and worth stating. A rolling fund buying at new higher rates does earn more going forward, and over a period roughly equal to its duration that added income tends to offset the price loss. That is a real effect and it is an average over a horizon, not a date on a contract.
A worked example
A fund with an average duration of 8. Rates rise one percentage point; the fund falls about 8%.
An individual ten-year bond, duration 8, in the same move. It also falls about 8% — and it redeems at 100 in ten years regardless.
Same exposure, different endings. The bondholder waits and is made whole in nominal terms. The fund holder waits and finds out.
And the fee runs throughout. On this site’s thirty-year measurement, an annual charge of 75 basis points costs 20.2% of the final balance and 150 costs 36.5%. Against a bond fund yielding 4%, a 75-basis-point fee is taking nearly a fifth of the income every year.
What to read on the factsheet
Average effective duration. The single number that predicts the damage from a rate move, covered in bond duration. It is published and almost nobody looks.
Credit quality breakdown. A fund holding high-yield debt carries credit risk that behaves like equity in a downturn, which is a different asset from a government bond fund wearing the same word.
And the ongoing charge. Against a low single-digit yield, the fee is a much larger share of the return than the same fee on an equity fund.
The original data
This site’s thirty-year fee measurement: 5 basis points costs 1.5% of the final balance, 20 costs 5.8%, 75 costs 20.2%, 150 costs 36.5%.
Bond funds sit at the sharp end of that table. Their gross yields are low, so a fee that looks modest consumes a large proportion of what the asset actually produces — the same 75 basis points is a fifth of a 4% yield and a fourteenth of a 10% equity return.
And the fund trades constantly to maintain duration — each roll paying a spread, inside the reported return, on top of the published fee.
The one structure that does have a maturity
Target-maturity bond funds exist and they solve exactly this problem. They hold bonds all maturing around a stated year, then wind up and return the proceeds — so they behave like a single bond with diversification across issuers.
That structure restores the date. A rate-driven fall recovers by the maturity year, because the underlying bonds redeem at par and the fund pays out what it receives.
They are far less common than ordinary bond funds, and they are the right answer for anybody whose plan depends on having a specific sum at a specific time — a school fee, a house deposit, the start of retirement.
The trade is flexibility. A rolling fund maintains its exposure indefinitely and suits someone who simply wants bonds in a portfolio; a target-maturity fund suits someone with a date. Choosing the wrong one of those two is the mistake this page exists to describe, and the choice is rarely presented as a choice at all.
When it fails
The characteristic failure is holding for a maturity that does not exist. The plan is the one that works for an individual bond: ignore the price, wait for the redemption date, collect par. A fund has no redemption date, so the wait has no endpoint and no mechanism behind it. People hold on through a recovery that may or may not arrive, believing they are being patient in the way a bondholder is being patient — and the two situations are not the same situation.
A second failure is buying a long-duration fund for safety, where the word “bond” carries an assumption the duration figure contradicts.
A third is treating a high-yield bond fund as the defensive holding, when its behaviour in a downturn resembles equity.
A fourth is ignoring the fee against a low yield, which is where it does the most proportional damage.
And a fifth is assuming the fund’s holdings are diversified in the way you need. Many are weighted by amount issued, which lends most to the most indebted — a property of the index rather than a choice.
Related
Bond market covers where the underlying holdings trade and why it costs what it does. Bond duration covers the number that predicts the fall. And expense ratio covers the fee against a low-yielding asset.
The single most common misunderstanding I see in personal finance is somebody holding a bond fund through a rate rise, telling themselves they will get their money back at maturity. There is no maturity. That plan belongs to an instrument they do not own.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.