Many investors assume that they’ve “lost money” in bonds when yields rise and prices fall. However, this isn’t exactly correct. In many cases, this “loss” is just a temporary mark-to-market correction that will fully recover over time. This is especially true when investing in individual bonds.
In this post, I’ll explain why this is the case, examine the unique risks associated with owning bond funds, and show how bond duration fits into all of this. Let’s dig in.
Why Waiting Keeps Your Bond Return Constant
Imagine you want to buy a 1-year U.S. Treasury bill with a yield of 4%. You login to TreasuryDirect (or your brokerage account of choice) and purchase a $100 U.S. Treasury bill maturing one year from today for $96.15. The price of this Treasury bill can be calculated as $100/(1 + 4%) or $100/1.04 = $96.15. In other words, you’ve agreed to give the U.S. government $96.15 today and they’ve agreed to give you back $100 in a year.
Now imagine that the moment after you buy your Treasury bill, 1-year interest rates instantaneously increase to 5%. Now, a new 1-year Treasury bill is paying 5% and can be purchased for $95.24 [or $100/1.05]. This also happens to be the price of the 1-year Treasury bill you have in your possession.
Because interest rates moved from 4% to 5%, your 4% Treasury bill became less attractive to investors and its price went down. This explains why bond yields and bond prices are inversely related. As market yields go up, existing bonds with lower yields must fall in price to offer the same return as the newer bonds.
So what’s your loss in this scenario? Well, if you bought a 1-year Treasury bill paying 4% for $96.15 and a new 1-year Treasury bill paying 5% only costs $95.24, the difference is $0.91 [$96.15-$95.24]. This $0.91 represents your mark-to-market loss if you sold your 4% Treasury bill today and did not reinvest the money.
But, what if you did reinvest it? Well, then your “loss” is only temporary. Let’s see why.
If you decide to sell your 4% Treasury bill today, you’d be paid $95.24 (ignoring transaction costs). If you then reinvest that $95.24 by purchasing a 1-year Treasury bill paying 5%, in one year the U.S. government would pay you $100. Similarly, you could hold your existing 4% Treasury bill, wait one year, and the U.S. government would pay you $100 (as originally promised).
In both scenarios you get your $100 back! The only requirement is that you have to wait for it.
This is why bond losses are only realized if you don’t hold until maturity. Because, technically, your nominal return is locked in from the moment you lend your money until the maturity date. If we ignore credit risk (i.e., the risk that you won’t get paid back from the borrower), then there is no chance that you don’t earn the nominal return you originally agreed to.
In our example above, this means that you will earn 4% on your 1-year Treasury bill…if you just wait. It doesn’t matter what happens to interest rates between when you buy and when your bond matures. Sitting and holding generates the nominal return.
Of course, the math is easy to see when we have an individual bond and an instantaneous change in interest rates. But what if you own a bond fund? How does it work then?
Can You Lose Money in a Bond Fund?
When buying an individual bond, it’s easy to see how your return works. You give up money today and (typically) are given back more money in the future. Ignoring inflation and credit risk, this is how you make money with a bond.
But when you buy a bond fund, you own a collection of individual bonds with various maturity dates. If interest rates move up in that scenario, won’t you lose money?
In the short term, yes. If you sell the fund and don’t reinvest at higher rates. However, if you hold the fund through the duration of the portfolio, the fund manager reinvests properly, and there are no other changes in rates, then you should earn the fund’s yield at the time of purchase.
Before we can understand why this is the case, we must first understand a bond’s duration. Duration is a measure of how sensitive a given bond or bond fund’s price is to changes in interest rates. As an approximation, a bond with a duration of 1 would decline by 1% in price for every 1% increase in interest rates. A bond with a duration of 5 would decline by 5% in price for every 1% increase in interest rates. And so forth.
In our example earlier, our 4% Treasury bill had a duration of 1 since it matured in 1 year and had no other cashflows. This is because Treasury bills are zero-coupon bonds, meaning they only pay you once at maturity. Therefore, when interest rates increased by 1% (up to 5%), we would expect the price of our 4% Treasury bill to decrease by 1%. In reality, its price decreased by 0.95% [$95.24/$96.15 – 1 = -0.95%] since this is an approximation.
Additionally, duration also approximates how long it takes to recover from a decline in bond prices (assuming you reinvest the income). Since our Treasury bill had a duration of 1, if we sold it and then reinvested the money, it would take approximately 1 year to earn our money back after interest rates went up.
That’s how duration works for individual bonds. For bond funds it’s similar in many ways. If a bond fund has a duration of 1, then we would expect its NAV to decline by 1% if interest rates increased by 1%. And if you wanted to make your money back in the bond fund, you’d have to hold that bond fund for 1 year (while it reinvests at higher rates) and hope that interest rates don’t increase further. If a bond fund has a duration of 5, then you would have to hold it for 5 years and hope that rates don’t increase over 5 years as well.
However, there is one big difference between individual bonds and bond funds. With individual bonds, your duration decreases over time and your final return is defined upfront. But with bond funds, the average duration resets constantly. Therefore, every day you’re re-exposed to the same level of duration risk as when you first bought the bond fund.
If you buy a bond fund today with an average duration of 5 and rates are unchanged for 5 years, you’ll earn the approximate yield the fund offered at the time of purchase. However, if three years into holding the fund, rates increase by 1%, you’d experience a ~5% loss (in NAV) and have to hold the fund for another 5 years to make up for this loss (assuming no other rate changes).
Unfortunately, bond funds expose you to risks that individual bonds don’t, especially in a rising rate environment. If rates keep going up, you will keep losing money in a bond fund. And holding through the original duration won’t change that.
This is true because bond funds have no end date, so they are regularly resetting their duration. As a result, you may have to wait much, much longer to offset losses in a bond fund versus a traditional bond. [Author’s Note: This logic assumes that the bond fund maintains a consistent duration and reinvests passively. Actively managed bond funds may behave differently due to shifts in duration or changes in credit exposure.]
The Bottom Line
I wrote this post because I believe that many investors have a misunderstanding of how bonds and bond losses actually work. Ignoring credit risk (i.e., the risk of borrower default), a bond is a guaranteed payment stream over a pre-determined amount of time. If you hold an individual bond for that pre-determined amount of time (i.e., to maturity), then you will never experience a loss in nominal terms. It’s that simple. Treat bonds like the agreements that they are and you should have nothing to worry about.
Unfortunately, many investors treat bonds as a “safe” asset class and expect no fluctuation in value over time. But this isn’t true, especially with longer duration bonds or bond funds that are constantly resetting their duration.
If you want safety, then you need to own the shortest duration individual bonds you can (e.g., short term U.S. Treasury bills). Not only will you get your principal back in a timely manner, but changes in interest rates will have little impact on your bonds’ value. So, even if you need to sell your bonds before they mature, you are less likely to experience a loss when doing so.
If you want to avoid bond losses, then you have a choice: buy shorter-duration bonds or…wait. Happy investing and thank you for reading!
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This is post 452. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data
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