How Bond Funds Can Lose Money

When Bonds Depreciate in Value

How and when do bond funds lose value?. Getty Images

Can bond funds lose money? A common misconception among beginning investors is that "bond mutual funds are safe" or that they confuse the term "fixed income" with prices that do not fluctuate. However, bond mutual funds can depreciate in value. But how does this happen?

Basics on Bonds and Bond Mutual Funds

Understanding how bond funds work must begin with how individual bond securities work. This is because bond mutual funds are pooled investments that hold bonds.

If you understand the basics of bonds, you can begin to understand the basics of bond mutual funds.

Let's say you decide to invest money in a bond, such as a 10-Year US Treasury Bond (aka 10-year T Note) and the bond is paying 2.00%. You buy $10,000 worth at a price of $100 each. Assuming you hold the T Notes to maturity, you will receive $200 (10,000 x 0.02) per year for ten years, at which time you would receive your $10,000 principal amount. This is why bonds are considered to be "fixed income:" Because the income (yield) is fixed to maturity. But what happens if you need to sell your bond before the ten years is up? This is where the perceived safety of bonds can get tricky.

When and How Bonds Decline in Value

This article's title is "How Bond Funds Can Lose Money" but investments never really "lose" or "gain" money until they are sold; they depreciate (decline) or appreciate (gain) in value based upon their price, or more accurately their Net Asset Value (NAV).

For example, you don't lose money when your house declines in value. That is unless you sell it when the value is lower than the purchase price!

Similarly, if the bond you purchase declines in value and you sell it prior to maturity, you will have to sell it at a lower price in the market and accept the loss, which is now a "realized loss."

What Makes Bonds and Bond Funds Decline in Value?

Bond prices move in the opposite direction as interest rates. Here's why: Imagine if you were considering buying an individual bond (not a mutual fund). If today’s bonds are paying higher interest rates than yesterday’s bonds, you would naturally want to buy today’s higher interest-paying bonds so you can receive higher returns (higher yield). However, you might consider paying for the lower interest-paying bonds of yesterday if the issuer was willing to give you a discount (lower price) to purchase the bond. As you might guess, when prevailing interest rates are rising the prices of older bonds will fall because investors will demand discounts for the older (and lower) interest payments. For this reason bond prices move in opposite direction of interest rates and bond fund prices are sensitive to interest rates.

Bond funds work differently than bonds because mutual funds consist of dozens or hundreds of holdings and bond fund managers are constantly buying and selling the underlying bonds held in the fund. As mentioned here previously, bond funds do not have a "price" but rather a Net Asset Value (NAV) of the underlying holdings. Managers also have to meet redemptions (from other investors withdrawing money from the mutual fund).

So a change in bond prices will change the NAV of the fund.

How to Invest In Different Interest Rate Environments

In an environment of rising interest rates, bond prices are generally falling. Again, this is because bond investors don't want to buy bonds that pay lower interest rates unless they receive them at a discount.

Furthermore, the longer the maturity, the larger the swing in price in relation to interest rate movements. In a period of rising rates and declining prices, the long-term bond funds will decline in value more than intermediate-term and short-term bonds. Therefore some investors and money managers will shift their fixed income investments to shorter maturities when interest rates are expected to rise.

When interest rates are declining longer maturities (i.e. long-term bond funds) can be a better bet.

In summary, a bond mutual fund can lose value if the bond manager sells a significant amount of bonds in a rising interest rate environment and investors in the open market will demand a discount (pay a lower price) on the older bonds that pay lower interest rates. Also, falling prices will adversely affect the NAV.

Bond funds are generally less risky than stock mutual funds. But investors are wise to understand that the value of a bond fund can fluctuate. The best idea for investors is to find suitable bond funds, hold them for the long term, and try not to pay much attention to fluctuations.