How do bond funds work?

[El Gringo]

I'm a young investor who has spent most of my time learning about stocks (and equity funds) than bonds (and bond funds). I have a general understanding of bonds (they're not too complicated, after all), but I'm curious as to how bond funds function in the bond market. Let's take the current status of the market as an example. Interest rates are incredibly low, and as they go up, individual bond prices will go down. How will that affect a bond fund, which is simultaneously holding older bonds (with low interest and now declining prices) as well as buying new bonds (with higher interest and higher value). As interest rates eventually go up, how will bond funds react?

[grantmeaname]

They'll tend to go down in proportion to their holdings, the same way an equity mutual fund will close at a lower NAV if the securities it owns decrease in value. An interesting statistic that you can look at for bond funds is duration (massive article here), which describes the interest rate sensitivity. Some bond funds, like unconstrained and multi-asset funds, can also short bonds, and their average duration can be near zero or even negative - this fund's is 1.5 right now, for example.

[Mr Mark]

Each fund will have a different blend of bond quality and duration. A short term bond to a solid counterparts can't drop too far, because if you simply wait a short time you get the original bond value paid back.

It's hard to see how long term bonds do well over the next 30 years. I'm actually negative on bond term investment long term, by having a long term fixed rate mortgage. I think the main holders are banks and insurance companies forced to hold them.

The more the fund can therefore reinvest at shorter terms when interest rates are rising the better the fund will do, but It will still go down (on the plus side, your yield will rise). Some funds hold corporate and non- us dollar denominated debt, so they can be impacted by corporate profitability and exchange rates.

[Kriegsspiel]

There has been a lot of talk on the Bogleheads forum on this topic too, if you want to go peruse over there for more discussion.

[aclarridge]

It's important to keep in mind that bond funds typically roll over the bonds once they expire, so a short-term, high credit rating bond fund is one of the safest investments around. As mentioned, even if the bonds lose value in the short term due to rates rising, bonds being held are constantly expiring and the notional automatically reinvested at the higher rate. If you hold the fund for about as long as the average duration of the fund, you're very likely to at least break even, even in an extreme rate-rising scenario. And past that point, you're doing well due to the higher rates.

I disagree that banks have a lot of exposure to long term interest rates in the sense that they give you a mortgage - the bank is an intermediary and typically issues its own long term bonds to the market, using the proceeds to fund your mortgage. Then your mortgage essentially pays the coupons of their bonds plus a premium, which they keep. They need to manage the money properly because the interest portion of your payment decreases over time, but it's my understanding that they don't take much risk in general (relatively speaking) due to the many mortgages/bonds they hold/pay at various terms.