Dumb question about bond index funds

[Abe]

Hi everyone, I have a dumb question about bond funds: are index funds more volatile in one regard than individual bonds (assuming one isn’t selling either) because the index funds have to sell assets to match the underlying index? My guess is actively managed funds will try to avoid selling bonds at less than what they purchased, and instead hold to maturity. Also if you held a bond to maturity (and the borrower hasn’t defaulted), you’d make whatever was the expected yield.

The reason I’m asking is the monthly earnings from my bond funds has not changed significantly over the last year even though their value is apparently down 4%.

My current strategy is essentially continuing to purchase bond and stock index funds, and rebalancing by purchasing shares rather than selling shares in one for another. I only check once a year on the bond funds, so just noticed this discrepancy today!

[SwordGuy]

It's not a dumb question!

I heard a number of explanations about how bonds worked before it finally clicked. 

First of all, it's really important to distinguish between bonds and bond funds (index or not).

If I buy a individual bond, it has a value it will be worth at maturity.   It will also pay interest, either periodically over the life of the bond or when it matures.

**Assuming** the company does not default on its obligation and performs as contracted **and** I hold the bond to maturity, the bond does not lose value.  It does what I contracted for it to do.   It's worth what I paid for it.


Those are two really important assumptions.  If the bond issuer defaults then the bond might drop to zero value or to pennies on the dollar at some future point after the company's assets are sold off to repay its debts. 


If I suddenly need cash and need to sell the bond to get it, things get more complicated.


What interest rate is it paying and how does that compare to the interest rate being used on newly issued bonds.


Let's say I have a bond with a maturity value of $10,000 and it pays 2% interest.   If new $10,000 bonds are paying 6%, who in their right mind would want to buy my bond at 2%?

The answer is, "Only a damned fool would pay $10,000 for 2% when they could buy 6% for the same price."

So, how can I sell my bond in a hurry then?  The way to do it is to sell my bond at a discount.  I'm not going to do public math, I'll just explain the concept.   If I sell my $10,000 bond for less than $10,000, then the effective return on that bond goes up.  If I give it the right discount, it will equal the 6% that newly issued bonds are getting.  More of a discount makes it more attractive to potential buyers.

That's how individual bonds work.

So, how does  bond fund change things?

First of all, it mitigates the risk that any given company goes bankrupt and I lose my entire investment.  In that way, it's like a stock fund.  Ditto, I'm buying a bit of many bonds instead of all of one bond, so it's much the same.

That's a definite improvement.

Where a bond fund is worse is what happens if I don't need to sell my bonds early for immediate cash but other people do (or just choose to do so).   If enough other people want to sell, those bonds will have to be sold and I'll take a loss on my bond fund.   

That's my understanding.

If other folks disagree, I would be happy to learn better!

[ILikeDividends]

Where a bond fund is worse is what happens if I don't need to sell my bonds early for immediate cash but other people do (or just choose to do so).   If enough other people want to sell, those bonds will have to be sold and I'll take a loss on my bond fund.   

Also, just my understanding:

I think the bonds held in the fund are discounted by the market, and the lower bond price (to match the current market yield for that maturity), is reflected in the daily NAV of the fund, regardless of buyers and sellers of that fund.

More to what I think your point is, sellers of that bond fund will require the fund manager to raise cash to pay for the redemptions of the fund.  That means the fund manager is forced to sell some bonds before maturity, even if the fund manager would prefer not to according to his strategy.

If your strategy is to never sell before maturity, then I don't think that strategy is possible to implement using a bond fund, because the rigor of implementing that strategy is, in part, subject to the whims of other investors in that same fund.

ETA: My above comments wouldn't apply to closed-end funds (CEFs); which is a completely different beast.

[MustacheAndaHalf]

index funds have to sell assets to match the underlying index? My guess is actively managed funds will try to avoid selling bonds at less than what they purchased

Not a dumb question, but the terminology is a little confused.  Bond funds always track their index.  Needing cash for people who want to sell the bond fund doesn't cause them to stop tracking the index.  For example, if a bond fund mostly holds 2 year and 10 year bonds, the fund can sell equal amounts of each.  They can also use special contracts to act like the fund is 100% invested, while keeping some cash available.

By the way, if you're really concerned about this, you can buy an ETF.  ETFs are shares bought and sold on the open market, so the company/person running the ETF don't deal with redemptions at all.  Instead, excessive buying gets reflected in the ETF's price/share.  Massive institutional traders watch for a tiny profit, and then create new ETF shares.  If an S&P 500 ETF is worth more than the 500 stocks within it, an authorized instutition buys each of the S&P 500 stocks until it adds up to 1 million ETF shares worth (for example), and then sells those shares to the market.  They profit off the difference in price - but it's very tiny to anyone else.

The financial markets have contracts which go something like "this contract acts like 100x 5-year bonds"... complete with dividends and changes in value.  A mutual fund manager can purchase a contract (or derivative) that acts like 5-year bonds, and keep some additional cash available.  I believe the Vanguard S&P 500 does this to remain ~100% invested while having a cash reserve.  So there's additional measures that smooth other the varying demand for buying/selling a mutual fund's shares.

[Boofinator]

Hi everyone, I have a dumb question about bond funds: are index funds more volatile in one regard than individual bonds (assuming one isn’t selling either) because the index funds have to sell assets to match the underlying index? My guess is actively managed funds will try to avoid selling bonds at less than what they purchased, and instead hold to maturity. Also if you held a bond to maturity (and the borrower hasn’t defaulted), you’d make whatever was the expected yield.

It doesn't matter whether a bond is held in an index fund or actively managed, or whether bonds are sold for less than what they were purchased or held to maturity, because as long as they are in the bond market (or any efficient market), all of these scenarios have the same expected return (for the most part*). Let's take the tale of two $1000 bonds purchased at 3% by two different funds (duration 1 year). The next day the interest rate for the same type of bond doubles. One company sells at a loss of 2.83% and buys a $971.70 bond at 6%, while the other company holds its $1000 bond to maturity. It's clear to see that at the end of the year, both companies will end up with $1030. Therefore, the bond that the second fund held to maturity still lost value, it just wasn't realized as it was for fund 1. (The longer the duration of the bonds, the bigger the effect: for the same scenario, a bond with two years duration would be purchased at $944.20. So for bonds with long durations, small changes in interest rate will have a small effect on earnings, but a large effect on fund value; but over the full duration, it evens out to the return projected.)

*The exception would be a big swing in the sale or purchase of bonds.

[Radagast]

Hi everyone, I have a dumb question about bond funds: are index funds more volatile in one regard than individual bonds (assuming one isn’t selling either) because the index funds have to sell assets to match the underlying index? My guess is actively managed funds will try to avoid selling bonds at less than what they purchased, and instead hold to maturity. Also if you held a bond to maturity (and the borrower hasn’t defaulted), you’d make whatever was the expected yield.

The reason I’m asking is the monthly earnings from my bond funds has not changed significantly over the last year even though their value is apparently down 4%.

My current strategy is essentially continuing to purchase bond and stock index funds, and rebalancing by purchasing shares rather than selling shares in one for another. I only check once a year on the bond funds, so just noticed this discrepancy today!

I'll answer in my way but it will probably repeat the gist of what others have said.
1. Index bond funds have the same interest rate volatility as single bonds. However, individual bonds with credit risk will likely be more volatile, a possible exception being if you don't bother looking up their selling price every minute of every day. The prices of the individual bonds will change every minute of every day regardless of whether you get a quote for it though.
2. A saying I have read about active bond fund managers is "in a crisis you don't sell what you want to sell, you sell what you can sell." If investors want their money out badly the managers will sell whatever somebody else is willing to buy. That may mean selling their shorter, higher quality, and safer bonds and keeping the losers.
3. If the active managers decide not to sell when rates rise they will shorten their fund's duration. That is taking reinvestment risk: the risk that rates will subsequently fall and they will miss the gains. This is a bet that over the long run will not pay off, though it could over the short run. Shorter duration results in less risk, less risk will eventually result in less gain. Unless they correctly guess the direction of interest rates repeatedly, which... good luck to them.

[Abe]

Thanks for everyone's explanations.

So in summary index funds mitigate the default risk of individual bonds by purchasing a diverse set of individual bonds. However, any bond fund is subject to risk of loss of principal if someone decides to sell their shares, and the bonds being sold to pay out are worth less than their initial value (due to rising interest rates)?

If I'm just buying and holding with the plan of eventually living (partly) off the yield, rather than selling shares intermittently, it ends up being a wash since whatever bonds the fund holds are still providing monthly interest payments. In addition, if they had to sell bonds in the above scenario, whatever shares I purchase going forward would just go towards higher-yield bonds, thus potentially negating that loss?

[Boofinator]

Thanks for everyone's explanations.

So in summary index funds mitigate the default risk of individual bonds by purchasing a diverse set of individual bonds. However, any bond fund is subject to risk of loss of principal if someone decides to sell their shares, and the bonds being sold to pay out are worth less than their initial value (due to rising interest rates)?

If I'm just buying and holding with the plan of eventually living (partly) off the yield, rather than selling shares intermittently, it ends up being a wash since whatever bonds the fund holds are still providing monthly interest payments. In addition, if they had to sell bonds in the above scenario, whatever shares I purchase going forward would just go towards higher-yield bonds, thus potentially negating that loss?

Exactly. Rising interest rates are a double-edged sword. Sucks to be the guy who is pulling his money out and realizing the losses, but great for the guy who is going to start receiving higher coupon payments (despite a lower value in their fund on paper). Just have to be patient as you wait for all the lower interest bonds to reach maturity for your principal to go back up.

[jacoavluha]

1. it's much easier to invest in a bond fund than individual bonds as an individual investor, especially for longer term money. For short term simplicity, T bills work really well

2. you want to match duration to your time frame. Total Bond is I think the best choice for long term investing, and with this you don't really have to worry about the interest rate environment. Not so much for short term needs, when you could be forced to sell your shares at a depressed price.