Bond funds - are they really safe?

[Tk_working_mom]

I've been wondering for years now and never found the answer but maybe someone here can enlighten me.

I know buying and holding a govt bond till maturity is safe - you get the coupon payments in between and the face value at maturity. Basic. The fluctuations in bond prices (caused by changes in the benchmark interest rates set by central banks) don't matter to you.

But can investing in bond funds be safe? Bond funds are impacted by bond prices, as they have to buy when some bonds mature and the NAV is marked to market. There is no maturity for a bond fund, when you want your money back you're never guaranteed to get the same amount of money you put in.

So why are bond funds considered safe? What am I missing? Are they actually safe? And if bond funds are not safe, then what's the alternative?

[captainspoke]

There are different flavors of bond funds--gov't, corporate, mortgage, high yield/junk, emerging mkt, etc.

Then, many such funds offer a maturity horizon: short, medium, and long term. Short might be 1-3 yrs, intermediate 5-10, and long 20-30. Short term funds are less interest sensitive, but traditionally have lower yields; long term bonds are most interest rate sensitive but generally have higher yields.

Many bond funds separate those things (and more), others go for the whole, overall bond market. Foreign bonds, at least in emerging mkts, can be dollar-denominated or bought/sold in the 'local' currency. (depends on your view of currency markets and the dollar)

Short term bond funds would generally be considered safest--least volatile in price. (given that you trust the overall bond market)

[StockBeard]

The bond fund I have (SCHZ on Schwab) says the following:

Investment returns and principal value will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than their original cost.

I'm not sure if this is a blanket statement they put on all their funds, but by default I am not expecting this investment to not lose principal value. As captainspoke mentioned above, there is a huge variety of bond funds, so you'd have to read the fine print of a particular bond fund to understand if it could lose money or not.

My understanding is that bond funds do not wait until bond maturity to sell the bonds (for many reasons), and therefore they do not have the same guarantee/protection you do when selling a typical bond at maturity.

[TokyoWart]

It's a common misunderstanding that holding bonds means you can avoid losses while a bond fund opens the possibility for losses because of trading within the fund by the fund managers. However, if you consider the opportunity cost of the investment, a bond and a bond fund of the same duration really behave the same in terms of your investment returns. Because transaction costs for individual bonds are often quite high, most investors who need bonds should be holding bond funds instead of individual bonds.

You want to judge funds by their "duration" which is related to the maturity of the bonds it contains but depends on coupons rate as well. Funds with longer durations are going to tend to have higher coupon rates but also increase or decrease in price more than short duration funds. You should be able to find the fund's duration searching online. Vanguard has a nice tool which illustrates how duration, interest rates and bond fund returns can relate:

https://investor.vanguard.com/insights/ ... s-duration

[mighty58]

I also had this same question, after my first purchase of a bond fund went down and I didn't understand why.

When you buy an actual bond as an individual, you're generally buying on the primary market, ie. you're buying a "brand-new" bond direct from the issuer (of course there is a financial institution as your go-between). You can then hold this to maturity and get payouts in the form of coupons. At maturity, you get your principle back.

A bond fund, however, does not just buy bonds, sit back, and collect the coupons. They are also buying and selling "used" bonds on the secondary market, as well as credit derivatives that ostensibly protect against the risk of a default, but which are also traded in their own right. Bond pricing for the secondary market is very complex, and involves assessing the value of the bond at that point in time, by looking at the coupon rate, amount of time remaining to maturity, the current "risk-free" rate, among other factors, at that time. Because bond funds are buying and selling all the time, the value of their holdings will fluctuate, and events like an interest rate hike or cut will affect them quite a bit.

It was all too complex for my admittedly limited brain power, and I've since generally stuck to equity indexes as it's easier for me to understand the underlying dynamics of what makes the price go up and down.

If you want a bond and want to keep the mechanics simple, just buy the actual bond.