“Individual bonds are safer than bond funds in times of rising interest rates because you get your principal back at maturity.”
There’s only one problem with that argument, say investment experts at Morningstar. It’s not true.
Now that rates look to be headed up, Morningstar researchers set out to answer the question:
“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.”
However, their findings show that thinking ignores the math behind the way we measure bond present values and investment returns. If rates rise from 2% to 4%, your $1,000 2% coupon bond might still be worth a nominal $1,000 when it matures. But you’ve lost money in performance terms, because you earned only 2% each year in income, while you would have been earning 4% with a newer bond.
So whether you buy an individual bond and hold it to maturity, or a bond fund that either holds bonds to maturity, or trades them for newer bonds paying higher interest rates, you end up with exactly the same return. One approach avoids capital losses but earns less income; the other may incur capital losses but earns more income.
Since total return is the sum of capital gains, capital losses, and income earned, the net dollar result with either approach is exactly the same.
Here’s how Morningstar sums it up:
“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.”
Morningstar also points out other advantages of bond funds over individual bonds:
“Bond funds offer better diversification, which is critical for bonds with credit risk where the upside of getting your money back can be smaller than the downside in the case of default. Transaction costs are high in the bond market and the large scale of bond funds helps to reduce expenses.”