Help me understand bond funds

[grandep]

Given all the recent talk about the potential of an imminent interest rate hike, I have been reading up a lot on bonds and bond funds. I feel like I understand about 80-90% of how the bond market works, but there are still a few things I'm stumped about.

I understand that if I buy and hold individual bonds to maturity then I have no risk of loss of principal (assuming no default). However, in a bond fund I will lose principal when interest rates rise because bond prices fall and bond fund managers sell their bonds at discounted rates. The part I don't understand is why would a bond fund manager choose to sell at this point? Why not continue to hold the bonds in the funds to maturity and use interest payments on those bonds to buy new bonds at higher interest rates, therefore avoiding principal loss? What is the incentive for a manager to sell and take the loss?

Please enlighten me in the curious ways of the bond market.

[Radagast]

Typically bond index funds target a certain range of bond maturities, or a certain duration. If the fund manager makes an active decision to do something different then it will no longer be an index fund. For example, Vanguard's Total Bond Fund targets bonds maturing more than one year in the future. If they randomly decided to hold for longer they would be breaking from their index.

Additionally, by holding a bond to maturity, the fund is failing to buy a new bond at a higher interest rate, which over the long run will result in lower returns because of opportunity cost. If your time horizon doesn't have a particular end date, generally your bond allocation should also not have a particular end date. If you do have an end date, then purchasing a bond and holding to maturity can make sense.

[DreamFIRE]

The part I don't understand is why would a bond fund manager choose to sell at this point? Why not continue to hold the bonds in the funds to maturity

This reminds me of a question asked in another recent thread.  You might be interested in another type of bond fund:

https://forum.mrmoneymustache.com/investor-alley/basic-bond-question/msg1902148/#msg1902148

https://wiserinvestor.com/bond-portfolio/

[Mighty-Dollar]

Given all the recent talk about the potential of an imminent interest rate hike

And the Fed's intention to raise rates 3 times in 2018 is already to some degree baked into the current prices of bond index funds.

Nobody can predict whether interest rates will go sideways for years, go up gradually, go up fast or even go down.

The bottom line is that you HAVE to own bonds otherwise you're fully invested in stocks. When stocks fall, money runs to the safety of bonds and vice versa. When stocks crash that's when you'll be happy that you own bonds. When you own bonds and stocks TOGETHER you don't worry about timing the bond or stock market. One protects the other.

Also most people own a total bond market index fund which has an average duration of about 6 years (less volatility). You're not exposed to the wild fluctuations of a 20 or 30 year bond.

[CorpRaider]

Yeah, basically quotation risk but what you said about holding to maturity and being unable to lose money made me think we also need to remember to "keep it real."  I think I'm going to do a blog post about that. 

Lots or people think they can't lose money in treasuries that are held to maturity or cash and that's true in nominal terms (nominal T-bond losses weren't even that bad during the stagflation 70's, but you lost out big time in purchasing power).

Trying to remember that has helped me avoid holding too much cash.  Cash is trash.