(READ TIME: ~5 MIN)

TAKEAWAYS:

• Not losing money by holding a bond until maturity is an illusion.

• The economic impact of market rate changes still impacts investors holding bonds until maturity.

• A bond index fund provides an investor with greater diversification and less risk.

A common misconception I come across often is that if one simply buys and holds a few individual bonds until maturity, they will not lose money.  This statement is most often given as the reason why they would prefer to hold individual bonds as opposed to a more diversified bond index mutual fund or exchange-traded fund (ETF).  Bond index funds have a daily price (like stocks) that fluctuates up and down daily and can sometimes show a loss; whereas an individual bond will pay its stated yield until maturity and then return your principal.

The Economics of Holding an Individual Bond to Maturity

Let’s take the case of a single $1,000 bond you want to buy and hold to maturity.  Let’s say this bond has a 4% coupon (i.e., yield) that is commensurate with current market rates (i.e., the rates available to investors at the time).  This $1,000 bond will pay you $40 of interest per year until it matures and returns your principal of $1,000.

The Illusion of Not Losing (or Making) Money

As time passes after purchasing your $1,000 4% bond, economics continue to change and play out.  As this happens, the interest rates available to investors change.  Sometimes, market rates go up (meaning an investor could get a better yield on a bond similar to yours), and sometimes, they go down (meaning an investor would have to accept a lesser yield on a bond similar to yours).  Since you are holding your bond to maturity, you don’t care.

You may not care if market rates go up or down, but that does not change the real economic impact of those changes.  For instance, if market rates increased to where an investor could now buy a bond like yours that yields 5%, how much would investors be willing to pay for your 4% bond if you were to sell it?  Your bond only pays $40 of interest per year, so the price of your $1,000 bond would have to drop to $800 so that your $40 of interest would be equivalent to the market’s new 5% yield ($40/800 = 5%).

Technically, you are not losing money if you hold the bond to maturity and get your $1,000 principal back.  However, economically speaking, you are still receiving a below-market yield of 4% ($40) making the bond sub-optimal.  There is psychological comfort in holding a bond to maturity, which is worth something, but there is no economic benefit.  It is akin to an ostrich sticking its head in the sand (the world is still out there).

Not losing (in the case of market rates rising) or not winning (in the case of market rates declining) is an illusion.  If market rates increase, you will still lose by accepting and holding what ended up being a below-market yield.  When market rates decrease, you will still win by accepting and holding what ended up being an above-market yield.

Why Not Then Choose a Bond Fund

As an investor, what is the difference between holding onto your $1,000 4% bond that pays you $40 or selling your $1,000 bond for $800 and buying an $800 5% bond that also pays you $40?  You cannot escape the real economic loss. 

So then, why should an investor take on the additional risk of buying a few individual bonds rather than a far more diversified bond index fund?  A bond fund is just a portfolio of individual bonds, generally held to maturity.  The difference is you don’t see the individual bonds that are held to maturity, but rather the “mark-to-market” price each day reflecting the aggregate value of all the bonds in the fund’s portfolio.  Sure, the daily price change is in your face, but we know there is no economic difference.

The benefit of a bond fund is diversification.  Vanguard’s Total Bond Market ETF (BND) has 11,107 bond holdings (and only a 0.03% expense ratio).  A fund’s SEC yield would be comparable to an individual bond coupon (or yield).  A fund’s SEC yield approximates the yearly after-expenses yield an investor would receive, assuming all the fund’s bonds are held to maturity and income is reinvested.  BND’s SEC yield at the time of this writing was 4.77%.

When Holding a Bond (or CD) to Maturity is a Valid Strategy

All of this said, there is a time when holding a bond or a CD to maturity is a valid strategy.  This strategy is best when you have a specific amount of funding you need at a specific time.  This strategy will ensure that you have the amount needed at the time needed. 

We use this strategy to build 18-month CD ladders for our clients to fund their monthly retirement distributions.  It’s not so much the yield that’s important to us as is having the specific amount of money when needed.  The CD ladder is a tool to manage against a negative sequence of returns event first and an investment second. (See our Insight entitled "How we Actively Manage Sequence of Returns Risk for Clients" for more)

If you want help transitioning out of your individual bonds or building an income ladder to meet your retirement spending needs, we are here to help. You can click here to schedule an informal, introductory Zoom call to get started.