Bonds or bond funds or bond fund ETFs? Which should I buy? What’s the difference? What happens if interest rates go up?
First, there are many factors to consider. If you have a definite date that you need the money and you buy really safe bonds or you’re wealthy and can buy enough bonds to be nicely diversified; individual bonds are the way to go. An advantage to owning individual bonds is that you normally don’t have to worry about losing any principal as long as you hold the bond to maturity.
However, a bond fund or a bond exchange traded fund (ETF) should serve you well when carefully selected and when held for the long-term. This is especially true in the case of intermediate or longer term bond funds. Most of the bond ETFs will have very low expense ratios. And you can select funds that give you a very well diversified bond portfolio. In the unlikely event that an investment grade bond in the fund failed, your exposure to that particular bond should be fairly limited.
Some investors are worried about the threat of rising interest rates. Interest rates and bond prices have an inverse relationship. If interest rates go down, bond prices go up. Right now interest rates are super low, so when the interest rates start heading back up: bond values will fall. When will this happen? No one knows for sure. It could be very soon or it could be several years from now.
When considering rising interest rates, with all else being the same, the shorter the amount of time to the maturity date, the less the value of the bond will fall. For those of you invested in short-term bonds and the bond funds invested in short-term bonds, you will see a small drop in price due to the interest rate change. The price drop will be more pronounced in intermediate term bonds (and funds that invest in those bonds). With the drop being most dramatic for the long-term bonds and funds. The good news is that ”bond dramatic” usually isn’t nearly dramatic as “stock dramatic”: think 2008. If the interest rates rise gradually, you may make in dividends close to what you lost in value.
The tricky part about bonds is that even if the value goes down due to rising interest rates, as the bond closes in on the maturity date the price will move back to the face amount of the bond. Hold it to maturity and you get the full value back. In a bond fund though, the manager of an actively traded bond fund may not hold the bonds to maturity. They may sale the bonds at a loss in order to buy new higher yielding bonds. Looking at the turnover rate of a fund may be a good indicator of how actively the manager trades the bonds. If the turnover rate is low and bonds are generally held to maturity, you would have a dip in price which would rise again as the bonds matured and were replaced with the new bonds with the higher interest rates. A bonus to this situation would be that you’d end up making more money in dividends, because of the new, higher rates, that could then be reinvested or used as income.
There are other risks involved in investing in bonds and bond funds. For a full discussion, consult your investment professional.
This blog is for educational purposes and is not intended to be used as investment advice. Only you and your investment advisor can determine what is appropriate for your individual circumstances.
