How Bonds Work
If you understand the basics of bonds, you can also begin to understand the basics of bond mutual funds and the differences and similarities between the two. Understanding how bond funds work must begin with how individual bond securities work. This is because bond mutual funds are pooled investments that hold bonds. But bonds and bond funds don’t actually work the same way, especially when it comes to pricing and performance. Suppose you decide to invest money in a bond, such as a 10-Year US Treasury Bond (aka 10-year T Note) and the bond is paying 2%. You buy $10,000 worth at a price of $100 each. Assuming you hold the T Notes to maturity, you will receive $200 (10,000 x 0.02) per year for ten years, at which time you would receive your $10,000 principal amount back. That is why bonds are considered to be “fixed” income. The income (yield) is fixed to maturity. But what happens if you need to sell your bond before the ten years is up? This is where the perceived safety of bonds can get tricky.
Are Bonds Safe? Factors Affecting the Price of a Bond
Bond prices can move up or down, although not as dramatically as stock prices. Here are the primary factors affecting the price of a bond: Prevailing interest rates: Bond prices generally move in the opposite direction of prevailing interest rates, which are driven by Federal Reserve Board policy. If interest rates are falling, bond prices are generally rising. In a rising interest rate environment, bond prices will generally fall. This is because the newer, higher prevailing rates will make previously-existing bonds less attractive to investors. Age of the bond: The longer the maturity, the larger the swing in price in relation to interest rate movements. In a period of rising rates and declining prices, the long-term bond funds will decline in value more than intermediate-term and short-term bonds. Therefore, some investors and money managers will shift their fixed income investments to shorter maturities when interest rates are expected to rise. Credit quality: Just like an individual wanting to get a loan, bond issuers must generally pay higher interest rates if their credit rating is poor. The primary rating agencies are Moody’s and Standard & Poor’s. The bonds with higher yields are often those that have lower credit ratings. Also called junk bonds, these high-yield bonds can see price declines in a weak economic environment.
How Bond Funds Are Different from Bonds
Bond funds work differently from bonds because mutual funds consist of dozens or hundreds of holdings and bond fund managers are buying and selling the underlying bonds held in the fund. However, when an investor holds single bond securities, the investor has control over the selection of the securities and the timing of purchase and sale. Bond funds never truly mature as do individual bond holdings. Holding an individual bond until maturity means the investor will receive the bond’s value. This does not happen with a bond fund due to the turnover of underlying holdings over time. Also, bond funds do not have a “price” but rather a Net Asset Value (NAV) of the underlying holdings. Managers also have to meet redemptions (from other investors withdrawing money from the mutual fund). So a change in bond prices will change the NAV of the fund.
Are Bonds a Safe Investment During a Bear Market?
Bonds and bond funds can help to diversify a portfolio, which can be especially beneficial in a bear market for stocks. When stock prices are falling, bond prices can remain stable, or even rise, because bonds become more attractive to investors in this environment. Bond mutual funds can lose value if the bond manager sells a significant amount of bonds in a rising interest rate environment and investors in the open market demand a discount (pay a lower price) on the older bonds that pay lower interest rates. Falling prices will adversely affect the NAV.
Bottom Line
Bond funds are generally less risky than stock mutual funds. But investors are wise to understand that the value of a bond fund can fluctuate. The best idea for investors is to find suitable bond funds, hold them for the long term, and try not to pay much attention to fluctuations.
